When it comes to comparing interest rates for a mortgage loan, home buyers often have the option of choosing a loan with a lower interest rate by paying discount points.
Simply put, discount points are fees charged by the lender to reduce (discount) the interest rate charged to the borrower. A point is equal to 1 percent of the loan amount. For example, with a $200,000 loan, one point equals $2,000. Points are usually paid out-of-pocket by the buyer at closing.
Paying points may seem attractive, because a lower interest rate means smaller monthly payments. But is paying points always a good idea? The answer generally depends on how long you plan to stay in the house. Let’s look at an example:
Mortgage Discount Points Example
John and Jane Doe are shopping for loan rates on a $150,000 home. Their bank has offered them a 30 year loan at 5.5 percent with no points. This works out to a monthly principal and interest payment of $851.68.
However, their bank has also offered them a loan at 5.0 percent if they agree to pay 2 points (or $3,000). At this lower rate, their monthly payment drops to $805.23, or a savings of $46.45 per month. So how do they determine what to do?
Paying Mortgage Discount Points Is For Long Term Home Owners
By dividing the amount they paid for the points ($3,000) by the monthly savings ($46.45), we see that they will have to own the house for 65 months (or just over 5 years) before they will start to see savings as a result of paying points. If John and Jane plan to stay in the house for many years, then paying points could make good sense. But if they see themselves moving to another house in the near future, they’d be better off paying the higher interest and no points. (Note: for simplicity, the above example does not take into account the time value of money, which would slightly lengthen the break-even time.)
Mortgage Discount Points And Federal Income Taxes
In the United States, one side benefit of paying points on a mortgage loan is that they are fully tax deductible for the same tax year as your closing. However, this does not apply to points paid for a refinance loan. For refinances, the IRS requires you to spread out the deduction over the life of the loan. For example, if you paid $3,000 in points for a 30-year refinance loan, you can only deduct 1/30 of the $3,000 each year for 30 years. If you pay off the loan early, though, you can deduct the remaining amount that tax year (before you rely on this as advice for taxation, please check with your tax professional).
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Joe Manausa is a real estate blogger, a real estate investor and the Broker and Co-Owner of Century 21 First Realty. He can be reached via e-mail through the Tallahassee Real Estate Website or catch his latest writings on the Tallahassee Florida Real Estate Blog , or by calling (850) 386-2001.
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{ 5 comments… read them below or add one }
Why in gods name would you want to waste your money paying points as low as mortgage rates are right now? Give people better advice for crying out loud you crackpot!
Good points. Pun intended.
Hey there “why?,” thanks for stopping by. Maybe you should have actually read the blog before you were so quick to impart your wisdom upon us. The answer lies within.
As a mortgage “guy” for the last 19 years, it’s great to see someone address the potential benefit of paying points for a lower rate. Many loan officers will advise against it because they’d rather see you take the higher rate which will improve the odds that they can call you sooner to refinance when rates drop lower (this is more true in a higher rate environment.)
The best analysis takes into consideration whether you’re paying the points out of pocket or including them in the loan (essentially using your home equity or seller paid closing costs to do it.) If you’re paying them out of pocket then you definitely should consider the time value of money factor and the “highest and best use” of your money. Do you have $3,000 on an 12% credit card that you could pay off instead?
Also, if you want to compare apples to apples, you should keep your cash flow, i.e., monthly payments, the same on each option and run an amortization table to compare the actual interest expense options you’re considering. On the option where you’re paying points, pay the same monthly payment amount as you would on the “no points” option. You’ll be paying extra toward principal and leveraging the value of the lower rate even more. This stratgy reduces the amount of time it takes you to “break even”. If you decide instead to take the payment savings and spend it elsewhere, just be sure to consider the opportunity value of that money too.
In the example you gave, assume it’s a refinance transaction and the homeowner was able to add the $3,000 discount to the loan amount. Also assume they took the $30.34 monthly savings (lower now since they financed the discount point and start at a higher loan amount) and paid extra toward principal to keep their payments the same ($851.68 per month.) Their break even point is now at 57 months and their 7 year net savings would be $2,474.82. 10 year savings: $3,785. Cash flow on the two options is exactly the same since they did not come out of pocket with any $ and their monthly payments are the same. This neutralizes the time value of money factor. Contrary to what the Why? dude said so rudely, in a historically low interest rate environment, paying points often makes MORE sense because the likelihood of having refinance opportunities again to even lower rates in the future to is very, very slim. If you’re going to the well, why not drink as deeply as you can and/or should depending on the likely length of your journey?
Case-by-case, clear analysis of all factors involved is required.
Great comment Mike. One point you made “Many loan officers will advise against it because they’d rather see you take the higher rate which will improve the odds that they can call you sooner to refinance when rates drop lower.” I had never considered …. thanks for the warning.
The other point I hope others get from your comment is that we most likely won’t have a future refinance time when rates are this low or lower. So “get” while the “getting” is good!
Thanks again for your insight.
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