When buying a home, every bit of money you can save matters. Have you truly left every stone unturned? Well, you may have overlooked a little known but powerful option - discount points.
Depending on your situation, discount points could help you get the lowest possible rate on your new mortgage. Keep reading to find out whether or not discount points could work for you.
What are discount points?
"A discount point is a cost that a borrower pays to 'buy down' their interest rate," said Brent McDonald, senior mortgage loan officer at Amerifirst Financial in Scottsdale, Arizona.
Calculating a discount rate is simple: One point costs 1 percent of the loan amount, explains McDonald. Depending on the borrower, each discount point lowers your interest rate by one-eighth to one-quarter of your interest rate.
For example, on a $200,000 loan, each point would cost $2,000. Let's assume the interest rate on a 30-year mortgage is 4 percent and each point knocks off 0.25 percent. So buying two discount points will cost $4,000 upfront and result in an interest rate of 3.5 percent.
Discount points don't reduce the amount you've borrowed, but they do lower your interest rate and monthly payments. Perhaps you're still not convinced that you should spend money to save money. But according to our experts, it may make sense for some homebuyers.
When do discount points make sense?
Our experts say it depends on your situation.
"It's all about time horizon," says Gloria Shulman, president of Centek Capital Group, a mortgage broker and banking firm in Beverly Hills, California. "If a borrower expects to be in the home for over 15 years, it might make sense to pay points to lock in a lower long-term fixed rate."
However, if you do plan to stay in your home for the long term, here's how discount points would save you money.
For example, if you paid $4,000 to lower your interest rate to 3.5 percent on a 30-year fixed mortgage for $200,000, you would reduce your monthly payment by $38 each month. Therefore, it would take about nine years to save the same amount of the $4,000 upfront expense. During the last 21 years left on the mortgage, you will save $9,576 (252 months x $38 each month) by paying for discount points.
But this is an uncommon scenario, says McDonald. "Few people keep the same home or the same mortgage for the entire term," he says.
So if you're not sure how long you plan to stay in your home, how can you figure out if this is the right move for you?
Homebuyers and their mortgage professionals can make that call by calculating the break-even point, or the month when the total savings on monthly payments equals the cost paid for the discount point, says Anthony Van Dyke, president of ALV Mortgage in Salt Lake City, Utah.
In the example, the break-even point was about nine years. If the homeowners decided to stay an additional five years, they'd save $2,280 in monthly payments. But if they chose to stay even longer, say 10 years, they'd save $4,560.
"Points make sense for a home buyer when they plan on living in the house for a substantially longer period of time then the breakeven point," says Van Dyke.
He adds that discount fees can be used with any mortgage type, from FHA to conventional loans. However, just because they can be used, doesn't mean they should be.
When are discount points not worth it?
"Paying points is not ideal for a starter home if the borrower expects to be upgrading to another property within 10 years," says Shulman.
Van Dyke agrees: Discount points don't make sense when the borrowers plan to keep the home for only a short period of time, which is a typical scenario for young homebuyers with growing families, says Van Dyke.
He recently met with homebuyers who fit that bill - a couple who were expecting their first child and looking to buy a $150,000 condo.
"The condo they were buying had three bedrooms," says Van Dyke. The couple planned to use one bedroom as an office and another bedroom as a nursery for their second child, who they plan to have in three to four years, he says. "Their intentions were to sell the condo and buy a larger house sometime after they have their second child. They planned on living in this condo for three to five years."
Van Dyke calculated their break-even point to be 39 months. His advice to the couple? Don't buy points.
"Because it was possible they would not realize any savings or very little depending on when they moved, we decided it would not be financially wise to invest $1,700 cash today in a discount fee," he says. The couple decided to instead use that money to invest in baby things and home improvement items.
Shulman adds that discount points don't make sense for adjustable-rate mortgages (ARMs). These mortgage loans have interest rates and payments that aren't fixed, but move up and down, according to the U.S. Department of Housing and Urban Development website. So ARMs may offer even lower rates than fixed rate products with discount points, says Schulman.
Plus, on an ARM, discount points will only reduce your initial interest rate, but they won't effect the rate on your mortgage after the adjustment period. As a result, it's unlikely that you would have enough time to make it past the break-even point and see any savings.
Can we get discount points when we already have a mortgage?
Homeowners who already have a mortgage can only buy discount points if they refinance.
"One must buy down the rate during the purchase or refinance transaction," McDonald says. "Once the loan is closed, the terms of the instrument can't be changed without refinancing, which is costly."
The only qualification is that you have the money to buy the discount rate, he explains. However, discount rates aren't as popular as they once were.
"Back when rates were much higher, people were more inclined to pay extra to buy down the rate," he says.
Are there any additional perks to discount points?
In addition to lowering your rate and monthly payments, discount points have another major perk: They are fully tax-deductible. Why? Well, they're considered upfront interest by Uncle Sam, says McDonald.
Also known as prepaid interest, the IRS website says if you are eligible to deduct the interest on your mortgage, you may be able to deduct the cost of buying discount points, too.
"If you are filing married or joint income taxes in 2013, and your household income is $75,000, you would be in the 25 percent tax bracket," says McDonald. He says that every $1,000 paid for discount points equals a $250 tax deduction.
People in a variety of tax brackets could benefit from buying discount points if it saves them money in the long run. But the higher the borrowers' tax bracket, the more they'll be able to benefit.
Why? Because they will see more of a tax deduction since they pay more tax. Van Dyke says he worked with one couple on a $821,000 jumbo loan purchase in 2013, and thanks to discount points, their tax deduction equalled more than $19,000 in long-term savings.
"The borrowers were high income earners and were very conscience of tax savings," he says. "[They] chose to pay a 1.5 percent discount fee of $12,315 to lower their interest rate 0.5 percent," says Van Dyke.
Doing so saved them $231 per month or $2,772 per year. Their pre-tax break-even point was 4.4 years, however the tax deduction reduced that, says Van Dyke.
"The $12,315 in points paid equates to $4,063 in tax savings based on a 33 percent tax bracket," he explains. This dropped their true after-tax breakeven point down to 2.9 years. For a couple in the 25 percent tax bracket, their tax savings would be $3,078.
"These borrowers plan to live in this house for 10 plus years," says Van Dyke. Over 10 years, Van Dyke calculates the borrowers will save $19,468 - found by multiplying the savings of $ 2,772 each year by 10 years.
The Bottom Line
While borrowers can benefit from the lowered interest payments from discount points, it's not a one-size -fits-all strategy. First, figure out how much you'd be able to reduce your monthly payments, then ask yourself how long you plan on living in your home. Discount points may be worthwhile if you plan to stay in your home long enough to recoup the upfront cost of discount points and save a substantial amount of money in the long run.
- interest rate
- discount points