Should you pay discount points to lower your interest rate?
Discount points outlined
- Discount points are often misunderstood as extra costs.
- Discount points are purchased voluntary on the front end of a loan to lower interest payments over its lifetime.
- For most people, discount points may not make economic sense.
- Discount points can be used as a way to pay off the mortgage more quickly.
Mortgage rates vary depending on many factors, including the term of the loan and whether the buyer chooses a fixed- or adjustable-rate loan. The rates also can vary depending on the particular loan product a borrower chooses — such as a conventional or a government-backed Federal Housing Administration (FHA) loan.
Homeowners also can lower their monthly mortgage payments by paying upfront “discount” points. Discount points are not fees to cover the administrative costs of making the loan, but are essentially a voluntary interest prepayment.
Discount points, sometimes called discount fees or a permanent loan buydown, are often misunderstood as extra costs, said Joe Parsons, a California-based senior loan officer who is the author of the consumer blog, The Mortgage Insider.
“People incorrectly view points as being somehow punitive or more money in the pocket of the evil lender, or the evil broker or loan officer,” Parsons said. “That is really not the case. The lender and the loan originator are going to make the same amount on the loan regardless of the interest rate.”
Once homebuyers compare lenders and determine the best mortgage loan program for their situation, a loan officer often presents several different possible rate scenarios. The rates are frequently updated, in some cases more than once a day, and the loan officers and brokers are working off rate sheets.
The final rate that the homebuyer is quoted will often depend on if that buyer elects to pay upfront discount points.
Generally speaking, if the homebuyer pays one discount point on the mortgage, it will lower the interest payment by 0.25 percent. So, if the rate is 4 percent without discount points, it would be 3.75 percent if the homebuyer pays one discount point upfront.
One point translates to 1 percent of the overall mortgage amount. For example, on a $100,000 mortgage, one point equals $1,000.
Although it is often tempting for a homebuyer to pay discount fees to lower the interest rate, for “the vast majority of people” it doesn’t make sense, according to Parsons. The monthly savings on the loan payment is often under $50 a month, and it can take a few years for the buyer to recoup the money that was laid out to pay the discount points.
“The practicality of it is that most people, in my experience, don’t manage and track their finances so meticulously that a $20 or $25 difference in monthly payments makes any kind of a difference at all,” Parsons said. “However, you do notice the difference with the cash out of your pocket right off the bat.”
Discount points can be a useful tool for people who plan to stay in their homes for many years or want to pay down their mortgages more quickly, however. On loans used to purchase homes, the discount points also are tax deductible.
“If their goal is get the house paid free and clear as quickly as possible, then paying discount points definitely is a good economic strategy,” Parsons said. “It is something that can be easily calculated.”