When you’re shopping for a mortgage, you may have come across the term “discount points” or “mortgage points.” Essentially, these are fees that you can pay upfront to your lender in exchange for a lower interest rate on your mortgage.
The question is, should you pay discount points when applying for a mortgage? In this article, we’ll explore the pros and cons of paying discount points to help you make an informed decision.
What Are Discount Points?
First, let’s define what discount points are. A discount point, also called a mortgage point, is a fee equal to a percentage of the loan amount. For example, if you’re borrowing $300,000, one discount point (1%) would cost you $3,000. When you pay discount points, you’re essentially prepaying interest on your mortgage, which allows you to secure a lower interest rate.
How Much Does One Discount Point Reduce the Rate?
The amount that one discount point can lower your interest rate varies depending on your lender and the current market conditions.
However, as a general rule of thumb, paying one discount point can lower your interest rate by 0.25% to .50%.
Advantages of Paying Discount Points
Lower Monthly Payments
One of the primary benefits of paying discount points is that it can lower your monthly mortgage payments. When you prepay interest with discount points, you’ll be able to secure a lower interest rate, which translates to lower monthly payments.
For example, let’s say you’re taking out a 30-year fixed-rate mortgage for $300,000 with an interest rate of 5.5%. Your monthly principal and interest payment would be $1,703.
If you decide to pay one discount point upfront, which costs you $3,000, you may be able to lower your interest rate to 5.00%. This would lower your monthly principal and interest payment to $1,610, saving you $93 per month.
Over the life of your mortgage, this could add up to significant savings. However, keep in mind that it may take several years to recoup the cost of paying discount points, so you’ll need to stay in your home for a while to make it worth it.
Lower Total Interest Paid
In addition to lower monthly payments, paying discount points can also lower the total amount of interest you’ll pay over the life of your mortgage. When you secure a lower interest rate with discount points, you’ll be paying less interest on your mortgage every month, which can add up over time.
Using the same example as above, if you decide to pay one discount point upfront and lower your interest rate to 5.00%, you’ll save around $33,480 in interest over the life of your 30-year mortgage.
In most cases, discount points are tax-deductible. This means that you can deduct the cost of the points from your taxable income, which can reduce your overall tax burden. However, it’s essential to consult with a tax professional to determine how paying discount points will impact your tax situation.
Disadvantages of Paying Discount Points
The primary downside of paying discount points is that it requires upfront costs. As we mentioned earlier, one discount point is equal to 1% of your loan amount. This can add up to several thousand dollars, depending on the size of your mortgage.
If you’re already struggling to come up with the down payment and closing costs for your home, paying discount points may not be feasible.
You’ll need to factor in the cost of discount points when budgeting for your mortgage and ensure that you have enough cash reserves to cover the upfront costs.
Long Break-Even Period
Another disadvantage of paying discount points is that it can take several years to recoup the cost of paying discount points. Even though paying discount points can lower your monthly payments and total interest paid over the life of your mortgage, it can take a while to see those savings.
Using the example from earlier, let’s say you paid one discount point upfront ($3,000) to lower your interest rate from 5.5% to 5.00%. In this case, it would take you about 2.7 years (32 months) to recuperate the $3,000 before you realize actual savings.
Interest Rates Could Fall
Finally, it’s worth noting that interest rates could fall after you’ve paid discount points. If this happens, you may end up paying more in interest over the life of the loan than you would have if you had not paid discount points and instead refinanced. This is something to consider when deciding whether or not to pay discount points.
Can You Negotiate Discount Points on a Mortgage?
Discount points are theoretically negotiable. But, in practice, that’s not always the case. The only way to know for sure is to speak with your lender or broker once you’ve been approved for a loan.
If you want to successfully negotiate discount points, one of the best things you can do is to shop with multiple lenders. Once you have your loan offers, you can let each lender earn your business by negotiating lower rates or closing costs.
The Bottom Line
Paying discount points when applying for a mortgage can be a smart financial move in some situations. By buying down your interest rate, you can enjoy lower monthly payments and reduced total interest paid over the life of the loan.
However, paying discount points can also be expensive, and it may not be worthwhile if you’re not planning to stay in your home for the long term.
Ultimately, the decision to pay discount points depends on your individual financial situation and goals. It’s important to weigh the pros and cons and see what best works for you.
By taking these steps and doing your research, you can increase your chances of finding the best interest rate on a mortgage that fits your needs and budget. Remember to consider factors beyond just the interest rate, such as the loan term, fees, and closing costs, when comparing loans from different lenders.
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