More than ever, mortgage borrowers are looking for ways to manage the amount of interest they pay. The Federal Reserve has raised the short-term fed funds rate resulting in average mortgage rates to more than double since 2021. In the search for interest relief, we have seen an increase in borrowers looking at their options, and one such common option is to pay more in mortgage discount points.
Mortgage discount points are a one-time cost paid to the lender in exchange for a lower interest rate on a home loan. Because the homebuyer is required to pay more money upfront, points raise the closing expenses. In turn, they lower the monthly mortgage payment and the total amount of interest paid throughout the loan’s term. When a lender states you can “buy down” the rate, they are referring to mortgage discount points.
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The cost of mortgage points is typically 1% of the loan amount. If you have a $300,000 mortgage, the cost of one point is $3,000. The point is typically equal to lowering your rate by .25%. Mortgage discount points are different from origination points, which are fees paid to your lender for giving you a loan. They are used to cover overhead costs for the loan.
So why would you pay upfront for a lower rate?
You may consider paying mortgage points when you need to lower your monthly interest cost to make a mortgage payment more affordable. This can make sense when your credit score doesn’t qualify you for the lowest rates available, but you have extra money to put down and you want an upfront tax deduction.
Time frame is important!
To justify paying the points, you need to consider how long it would take before you are able to recoup the upfront costs. For instance, if you are financing $300,000 and you purchase 2 points to buy the rate down from 7% to 6.5%, you are lowering your payment from $1,995.91 to $1,896.20 per month. One simple calculation would be to divide $6,000 (the amount you paid for the points) by the $99.70 per month you would save. Using this method, it would take approximately 60 months or 5 years to recoup the costs. If you receive a tax reduction when you file taxes for paying the points and count that in your calculation, you would recoup your money even sooner.
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So how long do you plan to stay in the home? If you plan to stay in the home for at least 5 years, then there is one other factor you may want to consider and that is the likelihood of you refinancing the home if rates come down. I had the privilege of buying my first home in the early 2000s when interest rates were in the same ballpark as they are today. 6.5% was considered a decent rate at the time, but interest rates fell to historic lows a few years later and I ended up refinancing that home at a lower rate. If you believe there is a decent chance you would refinance the home within that 5 year period, it may make sense to hold off on paying more cash upfront.
Other methods to lower your rate.
Paying for mortgage discount rates is not the only way to lower your rate. Consider strategies like shopping and comparing mortgage rates with other lenders. Also make sure your credit is in the best possible shape. If you are on the edge of a fair and good credit score, paying down some credit cards could help push your score up and qualify for cheaper financing. Finally, if you can afford a shorter mortgage term, you can sometimes get mortgage rate concessions and save tens if not hundreds of thousands of dollars by paying the home off in 15 or 20 years instead of 30 years.
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