When taking out a mortgage, or refinancing an existing loan, one of the goals should be trying to obtain the lowest interest rate possible. Of course, accomplishing that will depend on multiple factors, including the amount of the mortgage, the down payment, and the applicant’s financial details.
There is another way to reduce the interest rate, which consumers unfamiliar with the mortgage process are probably unaware of. When closing on a mortgage, a homeowner will have the option to buy mortgage points from the lender, also known as “discount points”. This additional fee, tacked onto closing costs, is essentially a way to “buy down the rate” of the mortgage and save on interest over the life of the loan.
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So how exactly does buying mortgage points work? How much can you save, and when does it make sense to do it? Here is a comprehensive crash course on the topic.
How mortgage points reduce your rate
When it's time to lock in your rate, the option for buying mortgage points will surely come up, if not beforehand. (In fact, most mortgage ads online have discount points baked into the APR offers). First off, it’s important to understand the difference between discount points and origination points. The latter is simply a fee paid toward the originating, reviewing, and processing of a loan, which has no effect on lowering the mortgage rate.
With discount points, every point you buy is typically equal to one percent of your total mortgage amount. For example, if you take out a $500,000 mortgage, buying one mortgage point will cost $5,000. So what exactly does that buy you as a homeowner? The cost of one mortgage point usually averages out to a 25% reduction off your interest rate. If your rate is 4%, buying one point may lower your rate to 3.75%.
It’s important to note, however, that buying points, as far as the amount it will cost you and the subsequent reduction to your mortgage rate, will vary from lender to lender, and also depend on the type of mortgage you have and the current interest rate environment.
There are other variables to consider when it comes to buying points. Most lenders allow you to buy fractional points, meaning instead of buying one point for $5,000, you can buy a half-point for $2,500, although your interest rate will only be reduced by half as much. You can also buy multiple points, although lenders typically have caps on how many points you can buy.
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The Crucial Break-Even Point
Obviously, if you’re spending thousands of dollars on discount points, you’re going to want to see that discount pay off. Buying points lowers your mortgage rate, which is reflected in a lower monthly payment. The break-even point marks the point in your mortgage when the total money you save on monthly payments equals how much you paid at closing for discount points.
There is an easy equation for determining when your break-even point will be; simply divide the cost you paid in points by how much you save monthly on your mortgage payment. The resulting figure is roughly the amount of months it takes before you break even. After that point, the money saved on your monthly payment becomes a net positive, since you’ve recouped your initial investment.
Fixed Rate vs Adjustable Rate
As a homeowner, the type of mortgage you have weighs heavily on whether buying points makes sense, specifically if you are choosing a fixed rate or adjustable rate mortgage (ARM). With a fixed rate mortgage, the reduction you get from buying points is reflected over the life of the loan. With an ARM, however, it’s more complicated. Your reduction can be reflected for the initial fixed rate period of the loan (typically 5-7 years for an ARM), but that may not be the case for when the adjustable rate kicks in.
While some lenders may lower rates for ARMs after the fixed rate period, it’s also important to know that once you refinance a loan, you lose the benefit you gained from buying points. For this reason, it makes more sense to buy points for a long-term, 30-year fixed mortgage. The main reason being, you want to still have the original loan and be living in the home after the break-even period to truly benefit from the reduced fixed rate.
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Buying points may seem complicated, but the longer you plan to keep the same mortgage, the more sense it makes from a savings standpoint. It’s important to run the numbers, as far as finding out when your break-even point is, and how much you can ultimately save on monthly payments compared to what you paid at closing. By lowering your monthly payment, buying points can serve as a budgeting tool for some homeowners.
However, for those overwhelmed by closing costs, buying points may not make sense financially at the time. Furthermore, for those who plan on: paying off their mortgage in a short time frame, selling their home, or refinancing their mortgage, buying points may not even allow you to hit your break-even point.
In addition to buying points, homeowners can also save money on interest by increasing their down payment. Doing so can potentially lower your mortgage rate and monthly payment, while also reducing (or eliminating) mortgage insurance costs, which buying points cannot achieve.
For all the reasons above, it makes sense to calculate which options make the most sense for you at closing. It can be increasing your down payment, buying discount points, or a combination of both. Either way, with Fiona, you can compare mortgage rates from multiple top lenders, each with their own unique advantages as far as buying points and getting competitive rates catered to your personal needs.
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