First things first. Make sure you understand what points are. Points (or discount points) are simply pre-paid interest. One point amounts to 1% of the total mortgage. If you have a $100,000 mortgage, one point costs $1,000. That’s pretty much all there is to it.
Now, why would anyone pre-pay interest? Good question!
You pre-pay interest to get a lower interest rate for the life of your loan. And because points are pre-paid interest, you can, in most cases, deduct them from your taxes in the year that you pay the points. That’s a nice one-time tax benefit!
So, if you want the lowest interest rate possible on any given day, you’d have to buy points, which is also called “buying down your rate.” Every day, when rates are issued, a certain amount of points are tied to certain interest rates. For example, if you’ve heard the term “zero point rate,” that means that rate has no points attached to it. You get that rate without pre-paying any interest. A one point rate would have one point attached to it and a two point rate, two points attached to it, etc.
If you want a rate below the zero point rate, you have to pay points to your lender. If you are willing to accept a rate above the zero point rate, you can actually get money back or a credit on your closing costs. This is often how “no closing cost” options are created – you typically get a loan with the highest interest rate available and a lender will credit back all your normal closing costs.
To find out if buying points will pay off for your situation, here’s some simple math you can do (go ahead, whip out the calculator):
OK, let’s assume you are considering two options on the day you want to lock your mortgage interest rate:
- a 5.25% mortgage interest rate that costs you one point.
- a 6% mortgage interest rate that costs you zero points.
In this scenario, you would lower your rate to 5.25% by buying one point upfront. This costs you $1,000 (1% of $100,000).
Now that you have your basic numbers, it’s time for some basic math. To figure out if buying points makes sense, divide the cost of points paid ($1,000 in the example above) by the difference in monthly payment between the two rates. In the example above, the difference in payment is $47.35 ($599.55 – $552.20). If you divide $1,000 by 47.35, you’ll get 21.12. This is the number of months it’ll take you to break even.
To summarize, it would take you just under 22 months to recoup your pre-paid interest money and from then on you would enjoy your low 5.25% for the duration of your remaining mortgage. If you think you will be in your home longer than your break even point, you’re saving money from that point forward. Now that’s a good investment!
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