Should I pay discount points?
Should You Buy Points?
To buy or not to buy, that is the question clouding every homebuyer's mind when it comes to points.
A point is a fee you pay the lender at closing in exchange for a slightly lower interest rate. Each one is equal to 1% of your total loan and reduces your interest rate by precisely 0.125.
For example, in the case we'll examine later, the homebuyer has taken out a $250,000 loan over 30 years with a 6.5% interest rate. Each point is equal to 1/100 the value of the home, or $2,500, and would reduce the interest rate to 6.375%.
Are you confused yet about the value of points on a long-term loan? You're not alone, so perhaps it's easier to look at them as a way of coercing your lender into giving you lower interest rates. Sometimes buying a few is a good idea, but not always. Fortunately, you don't need to be a real estate mogul or a tax relief specialist to figure out if they are worthwhile.
You just need to enlist the help of the above calculator, and about 3 minutes of your time.
What Are Discount Points?
Since the real estate market can be volatile, lenders are open to the idea of receiving a lump sum from you as you move into the house, rather than waiting to collect all their fees month by month. If you have the cash left over after all the closing costs, commissions, inspection fees, taxes and what-not, points are a viable option for you.
Don't confuse points with a loan origination fee. While points are like paying it forward now to reduce your overall payment for years to come, an origination fee is a one-time processing fee for the loan itself, but it doesn't count towards anything and disappears into thin air.
This origination fee is typically equal to 1% of your loan, just like a discount point, but it's a completely different type of charge.
In case you didn't know, it doesn't hurt to ask the seller to cover a couple of your points for you. Many sellers are willing to work out a deal if it facilitates the sale.
Are They Tax Deductible?
Yes, but only in the first year, and only if the loan is used to build, buy or renovate your main home. They are not deductible on any other homes or rental properties you own.
It's easy enough for the IRS to verify your tax deductions for points. The lender is required to report to the IRS them. The deduction is listed on IRS Form 1098 submitted by the lender, and must match your deduction on Schedule A of your 1040 form.
Another deduction that borrowers can claim is any penalty fees associated with pre-paying extra on your mortgage, or paying off the debt early. These penalty fees are fully deductible.
How Much Do They Cost?
Equal to 1% of the value of your mortgage, each point of a $250,000 note would cost $2,500. Let's enter that data above and see what happens when we buy two:
Each one lowers your interest rate by .125% so two would cost $5,000 and bring 6.5% down to 6.25%.
What that means in real dollars and cents is a saving of $40.88 monthly for the duration of the loan.
We are using the equation "1 mortgage point = 0.125% interest rate reduction" because that's the formula used by most lenders. You may be able to swing a better deal, but 0.125% is what you can expect to find.
The effect points have on your payments are shown above in a split-second, but here's how the calculation is done:
- Determine the amount of your payment at the original interest rate.
- Determine the amount of your payment at the lower rate that points will get you.
- Deduct figure 2 from figure 1 and you have the amount saved each month or $40.88 in the above example.
- Now divide the amount you paid for the points by the monthly savings, and you will see the number of months it will take you to make back the cost; in this case 244 months.
When Do You Break-Even?This is your "break-even point" and it should be the main factor in deciding how many points to invest in, if any. In the example above, it would take the borrower 244 payments before they started to see any benefit.
If your break-even is 244 months down the road, that's definitely something to consider. It means they won't do you any good for the first 20 years of the loan. That's a long time to wait for the pay-off.
Should You Purchase Points?
You should evaluate your personal finances and plans for the future. If you don't plan on staying in your home until at least the break-even date, it's probably not worth all the bother to pay points at closing.
The most important thing to know is that you don't need an expert's opinion or consultation to determine if points are beneficial to your situation; you just need a free calculator — and your thinking cap.