What’s the goal of just about every sport out there? To score points. Whether you’re talking about baseball, football, basketball, soccer, hockey, lacrosse, or volleyball, you need to score as many points as possible to win the game/set/match. With that thought process in mind, you’d probably think mortgage points are a good thing, right?
Not so fast, my friend.
Mortgage points can be a good thing. They can also be a very bad thing. The key to finding out whether buying mortgage points is the right move for you and your house hunt is to understand what they are and how they work.
What Are Mortgage Points?
Mortgage points actually fall into two categories: origination points and discount points. Origination points are upfront fees you pay when closing a home loan. The money goes to your mortgage lender to help pay for the cost of underwriting and securing the loan. These fees are standard with most home loans; however, some lenders advertise no-origination fee loans to attract new customers, while others may allow you to negotiate origination points down to a lower rate, particularly if you have a good credit score.
The second type of mortgage points are discount points. These are the points I’ll be focusing on here, because they are far more nuanced – and more controversial in the lending industry – than origination points. Say your lender offered you a home loan at a 4.5 percent interest rate, but you were looking for something lower. Some lenders give you the option of paying discount points to literally buy yourself a lower mortgage rate.
The Value Of A Discount Point
The price of a discount point varies depending on the value of the mortgage for which you are applying. Generally speaking, a discount point is worth one percent of your home loan, for example:
- one discount point on a $100,000 home loan is $1,000
- one discount point on a $250,000 home loan is $2,500
- one discount point on a $400,000 home loan is $4,000
You get the picture.
How Discount Points Work
Let’s pretend you were looking to buy a home for $250,000 with a down payment of 20 percent. That means your home loan would be $200,000. Now, let’s look at what you’d be paying monthly for that home by comparing two different interest rates.
Scenario A: 4.5% Mortgage Rate on a 30-year Fixed Loan
- $3,000/year for property taxes
- $1,500/year for homeowner’s insurance
- $1,388.37/month in mortgage/escrow payments
- $499,813 in total payments over the next 30 years
Scenario B: 4.25% Mortgage Rate on a 30-year Fixed Loan
- same $3,000/year property tax bill
- same $1,500/year insurance bill
- $1,358.88/month in mortgage escrow payments
- $489,196 in total payments over the next 30 years
Let’s breakdown the differences between those two scenarios. In Scenario B, you’d be saving $30/month in mortgage payments thanks to the slightly lower mortgage rate; overall, that would equate to just over a $10,000 savings over the life of the loan.
But what if your bank can’t offer you the lower interest rate on your home loan? That’s where points come in. Your bank might offer you the option of paying a discount point – one percent of the loan’s value, or in this case, $2,000 – in order to secure the 4.25 percent mortgage rate.
Do Discount Points Make Sense For You?
On the surface, you may look at the cost of a discount point – just $2,000 – and compare it to the overall amount you’d save over the life of your loan by securing the lower interest rate. Even paying for the point, you’re still saving $8,000 over 30 years. On top of that, you can deduct the cost of points on your 1040 IRS form, right along with your mortgage’s interest. Seems like a solid financial move.
For many potential homeowners, it is a smart move. If you have enough cash up front to put down a large down payment on your home – 20 percent or higher in order to avoid private mortgage insurance – points can be another way to reduce the cost of your monthly mortgage payments. However, in our increasingly cash-strapped society, the liquid assets just aren’t on hand to put down such a large down payment. In some cases, putting what you would spend on a discount point toward your down payment may help you save more money by reducing your principal on the loan or by helping you break into a lower tier of mortgage insurance rates. Rolling the cost of a point into your home loan is an even worse option. By doing so, you’ll be paying for not only the cost of the point itself, but you’ll be paying interest on it for the life of your loan.
The Investment Option
Let’s reconsider the original $2,000 you theoretically spent to secure that lower interest rate on your home loan. What if you invested that money instead? Assuming an eight percent return rate over the next 30 years, you could turn that $2,000 into nearly $22,000 without adding a single penny to it over the next three decades. That nearly triples the $8,000 you’d stand to gain with the lower mortgage rate. Even with more modest gains – say six percent instead of eight – you could still turn that $2,000 into more than $12,000, a better return on your money than paying for discount points. (However, if you diligently invested the $30 you saved on your mortgage with the lower rate, you’d be able to amass more than $45,000 – assuming an eight percent return – over 30 years.)
Reader, have you ever purchased discount points for your home loan? Why or why not?