Everyone wants the lowest possible interest rate when getting a mortgage. If you want to lower your monthly mortgage payments, lenders will let you “buy down” the rate by paying what are called “discount points.”
You pay these points up-front at closing. The more points you pay, the lower the interest rate on your mortgage. It’s designed to be a trade-off: the lender immediately gets a lump sum portion of your mortgage payment and you get to make lower monthly payments for the life of the loan.
Related: 10 Great Advantages of Owning a Home
Is it worth making an extra up-front cash payment to lower your monthly payment? The answer involves a combination of a financial and personal analysis. Buying a home indicates your life is changing, and almost by definition, it will continue to change in significant ways from here on.
So, assessing the value of paying a point or more to lower your monthly payments requires assessing your personal life needs in the future, not just for today.
First, let’s talk about the strategy of buying points.
Buying points and breaking even
Each point equals one percent of the loan amount (in this case, $2,000). The point(s) must be paid up-front at closing. For example, consider two offers from the same bank:
|Loan Amount||Years||Rate||Points||Cash Up Front||Monthly Payment|
The second offer lets you pay $29 less each month, but requires you to pay an extra $2,000 more in cash than the first offer. Which deal is better? The financial answer centers on the “breakeven point.” It would take 69 months — 5.8 years — of lower monthly payments to recoup the extra $2,000 in cash you would pay at closing. After that breakeven point, you would begin to come out ahead, at a rate of $29 a month.
Related: How Much House Can You Afford?
What if, instead, you paid 2 points and your rate dropped to 3.5 percent? You would save $58 a month, and it would take 70 months to break even, instead of the 69-month breakeven for paying one point. Not much difference, except you would come out ahead after that at a rate of $58 a month instead of $29.
Legislation called the Dodd-Frank Act that went into effect of 2014, placed stricter rules on mortgage practices and help protect against another housing crash. One of those rules states that the total points and fees can’t exceed 3 percent of the total loan amount.
Discount points were, for some reason, excluded from this rule, leaving no standardization for how much lower your interest rate offer might go for every point you are willing to pay.
Tip: A good rule of thumb is that every point should lower your rate by a quarter of one percent.
Each lender can set its own parameters. You will need to compare various loans against each other on a case-by-case basis. Find out what the latest interest rates.
In this financial analysis, the final question is, can you afford to pay the extra cash up front? If you’re cash poor and will struggle to pay the closing costs, the answer is no, and no further analysis is necessary. If you believe you can afford to let go of extra cash at closing, your analysis then becomes a mixture of financial and personal.
Assess your personal situation
The trade-off between paying cash now to pay less cash each month for your mortgage actually boils down to some basic questions about your life that impact your finances. These are questions such as:
- What will your life look like once you move into your new home?
- What are your next goals once you’re a homeowner?
- Do you want (more) kids? How soon?
- Is this a “starter home,” or one in which you could imagine living for 20 or more years?
- Do you plan to upgrade or repair the home? How soon? How extensively?
It’s always wise to keep enough cash on hand to cover unforeseen homeowner situations, from repairs to decorating opportunities.
There are also more pressing reasons to keep cash, from medical emergencies to job loss to growing a family and saving for college and vacations. So, how do you see your life moving forward?
Maybe you feel you can comfortably make the mortgage payments from the start and that your income will go up regularly from here. If so, it might be worth keeping the cash for yourself.
Maybe, instead, you feel you will struggle with monthly payments now, but they’ll get easier as your income level rises. If so, you might pay a point or two in cash now to ease the pain of monthly payments in the short-term.
Is there an ideal balance between points and rates?
Ultimately, this is the central question. The answer depends on how long you plan to hold the mortgage. There are two reasons for giving up your mortgage: the likelihood of moving to a new home and the possibility of refinancing to a better mortgage.
Tip: If you don’t expect to hold on to the mortgage for considerably longer than breakeven, then paying cash for points up front is not a wise decision.
Right now, interest rates are very low, and have been for so long, it’s hard to believe they could go anywhere but higher in the future. This may be one of the most beneficial times ever to lock in as low a fixed mortgage rate as you ever may be able to get.
Pundits and experts continue to debate whether rates will somehow go lower or will start to rise. You need to at least consider the likelihood that rates may soon rise. Since the main purpose for refinancing is to pay off a higher rate loan and get one at a lower rate, that time may never come for someone buying in today’s market.
If you eliminate refinancing as a potential reason to get a new mortgage before reaching breakeven, you need only assess the possibility of moving to a new home before breakeven. Asking yourself personal questions like the ones above will help you take a realistic view of the odds.
How much could you save over the very long run? Here’s an example, using the same variables as the example above:
|Loan Amount||Years||Rate||Points||Monthly Savings||By Year 15||By Year 30|
A few final considerations
If you want to reduce your out-of-pocket cash at closing and still get a lower rate, the lender may let you roll the points into the loan amount. In essence, you would be borrowing the money to pay for the points and then paying interest on that amount, too. If you’re going to increase your loan amount by the cost of the points, you need to recalculate how many months of mortgage payments it will take to get to breakeven.
Be aware that discount points are tax-deductible for the year in which you get the mortgage. The amount of savings from the tax deduction depends on your tax bracket. For example, if you’re in the 25 percent bracket and you pay $2,000 in points, you will get a $500 (25 percent of $2,000) tax break. Therefore, factor the tax break into your breakeven calculation, as well.
Keep in mind that the decision to pay points or not is more of an analysis of how you see your life today and in the future, than it is simply about the math. Part of how your life looks today should definitely include seriously considering taking advantage of extremely low interest rates that probably will eventually be as much as double or more what they are today.
Marc is a freelance writer for MyBankTracker.com who specializes in investing and retirement planning. He is an expert in asset allocation and portfolio management.