June 16, 2016
Lenders like to give home borrowers choices when it comes to their mortgage rate.
You’ll always be presented with a standard rate: what you qualify for based on how the lender sizes up your financial profile (credit score, income, debts etc.)
And then you will also be presented with some options to “buy down” or reduce that interest rate.
What’s the Point
The fee lenders charge to reduce the interest rate is called a discount point, or point. One point equals one percent of your loan amount. Typically every single discount point you pay will reduce your interest rate by about 0.25%. So for example, if you are applying for a $200,000 mortgage, you might be offered a 4% fixed-rate mortgage with no points and a 3.75% mortgage if you pay one point ($2,000 in this example). Or you could pay 2 points ($4,000 in this example) to lock in a 3.5% interest rate.
The trade off is that by paying to lower your interest rate, your monthly mortgage payments will be reduced. Over time the savings in your lower ongoing mortgage payments can offset the upfront cost of paying a point(s). You can use an online calculator to see your “break-even” point: when the savings from the lower mortgage cost will offset what you paid for discount points.
For example, if you paid $2,000 to buy down the interest rate on a $200,000 30-year fixed rate mortgage from 4% to 3.75% your monthly payment would drop from around $955 a month to $926 a month. It would take 69 months for the $29 in monthly savings to offset the $2,000 cost of the point. So, if you intend to live in that home for at least six years paying the point may make sense. If you intend to move sooner, than the higher rate mortgage with no points is likely the way to go.
Another reason to skip paying points is if you anticipate you will be able to qualify for a refinance in a few years at a much lower interest rate. That’s probably not in the cards right now given that mortgage rates are still near historic lows. But if for some reason you will be paying an above-market rate for a loan today (for example, your credit score is below 720 or so) you may indeed be in a position to refinance in a year or two at a lower rate.
Paying for Points
Depending on your market, you may be able to negotiate with a seller to cover some of your upfront costs, including a point or two.
Even if a seller or someone else pays for the points, you can get a tax break. Points paid upfront for a mortgage for your primary residence can be claimed as an itemized tax deduction. You can deduct the entire amount in the year you got the mortgage. Points you pay in a refinance can only be deducted over the life of the loan.