Securing a mortgage as a first-time buyer can be overwhelming, with various terms and options to consider. One such term is “discount points,” a powerful tool that can potentially save thousands of dollars over the full term of a mortgage. In this article, we explain what discount points are, how they work, and the benefits they offer.
What Are Discount Points?
Discount points are upfront fees paid to the lender at closing in exchange for a reduced interest rate. Each point costs 1% of the loan amount and typically lowers the interest rate by 0.25%. We spoke to Dana Hendrix from DSLD Mortgage, and he told us:
“Discount points, also known simply as points, are a form of prepaid interest that mortgage borrowers can purchase to reduce the interest rate on their loans. They can be beneficial for homebuyers who plan to keep their mortgage for a long time and do not anticipate financing or selling their homes.”
How Discount Points Work
When you take out a mortgage, lenders may offer you the option to buy discount points. The number of points you purchase will directly impact the reduction in your interest rate. Typically, each point purchased will lower the interest rate by about 0.25%, though this can vary depending on the lender and current market conditions.
Example Scenario
Imagine you have a $300,000 mortgage with a 30-year fixed rate of 4.5%. Without discount points, your monthly payment would be approximately $1,520. If you choose to purchase two discount points (costing $6,000), the interest rate might be reduced to 4.0%. This would lower your monthly payment to about $1,432, saving you $88 per month. Over a 30-year mortgage term, this reduction would result in significant interest savings.
3 Benefits of Using Discount Points
1. Lower Monthly Payments
One of the most immediate benefits of purchasing discount points is the reduction in monthly mortgage payments. This can make homeownership more affordable and free up funds for other expenses or investments.
2. Interest Savings Over Time
By reducing your interest rate, you also reduce the total amount of interest paid over the life of the loan. In the example above, lowering the rate from 4.5% to 4.0% can save you tens of thousands of dollars in interest payments over 30 years.
3. Tax Deductibility
In many cases, the cost of discount points is tax-deductible. The IRS considers points as prepaid mortgage interest, which can be deducted in the year they are paid, provided certain conditions are met. This can provide an additional financial benefit in the year of purchase.
3 Considerations Before Purchasing Discount Points
1. Upfront Cost
The primary drawback is the upfront cost. You need to have sufficient funds available at closing to cover the cost of the points, which can be substantial.
2. Break-Even Point
It’s essential to calculate the break-even point, the time it takes for the monthly savings to equal the upfront cost of the points. If you plan to sell or refinance your home before reaching this point, purchasing points might not be financially beneficial.
3. Long-Term Plans
Discount points are more advantageous if you intend to stay in your home for a long period. If there’s a possibility of moving or refinancing in the near future, the initial investment in points may not pay off.
Useful Mortgage Terms and Explanations
There are numerous terms you will come across during your mortgage application process. Here are some of the most common terms you should know:
- Annual Percentage Rate (APR): APR includes the interest rate plus other costs such as points, broker fees, and certain closing costs.
- Adjustable-Rate Mortgage (ARM): A mortgage with an interest rate that can change periodically based on a specific index or benchmark. ARMs typically start with a lower initial rate compared to fixed-rate mortgages.
- Escrow: An account held by a third party on behalf of the borrower and lender. Funds for property taxes, homeowners insurance, and sometimes mortgage insurance are collected in this account and paid when due.
- Loan-to-Value Ratio (LTV): The ratio of the loan amount to the appraised value or purchase price of the property, whichever is lower. A higher LTV indicates a higher risk for the lender.
- Debt-to-Income Ratio (DTI): The borrower’s monthly debt payments relative to their gross monthly income. Lenders use DTI to assess the borrower’s ability to manage monthly payments and repay debts.
- Private Mortgage Insurance (PMI): Insurance required for conventional loans with an LTV greater than 80%. PMI protects the lender if the borrower defaults on the loan.
- Principal: The amount of money borrowed for a mortgage, excluding interest. Principal payments reduce the loan balance.
- Title Insurance: Insurance that protects the lender or homeowner against losses from disputes over the property’s ownership.
Mortgage Discount Points: Take Away
Discount points can be a valuable tool for homebuyers looking to lower their mortgage interest rates and save money over the life of their mortgage. Discount points offer both immediate and long-term financial benefits by reducing monthly payments and total interest paid.
It’s crucial to consider the upfront cost, break-even point, and personal financial goals before deciding to purchase points. It’s advisable to consult with a financial advisor or mortgage professional to understand how market conditions might impact the decision.
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