If you'reor thinking about , chances are you've heard of . These points, commonly referred to as discount points, are a form of prepaid interest.
The concept is simple: You make a lump sum payment to your mortgage lender when you purchase or refinance your home in exchange for a lower interest rate and minimum payment over the life of your mortgage. When you make a trade like that, it's important that you understand the value on both sides of the coin.
Sure, a lower interest rate and mortgage payment seem appealing. But how much money will you have to spend to purchase points and bring your rate down?
How much do mortgage points cost?
Generally speaking, a mortgage point costs one percent of the total value of the mortgage. So, the exact dollar amount a point will cost you may vary. However, according to the St. Louis Fed, the average home in the United States costs about $431,000.
Assuming a 20% ($86,200) down payment, the total mortgage on the average home in the United States would be $344,800. So, you would need to pay $3,448 to purchase a discount point on this mortgage. Of course, your mortgage may include taxes and other fees you aren't paying for up front. Though, for simplicity sake, we'll keep those additional taxes and fees out of this example.
How much interest is each mortgage point worth?
When you purchase a mortgage point, you're essentially purchasing a lower. So, how much can a mortgage point bring your interest rate down?
Each point brings your interest rate down 0.25%. But what does that mean in dollars and cents over the life of a mortgage? Using the Bankrate amortization calculator here's what you could expect for two popular mortgage terms:
- 15-year mortgage: You'll pay $213,049 in interest on a 15-year $344,800 mortgage at 7%. If you buy your interest down to 6.75%, you'll pay $204,410 in interest over the life of the loan for a gross savings of $8,639. That works out to a net savings of $5,191 when you account for the $3,448 the point costs.
- 30-year mortgage: You'll pay $481,027 in interest on a $344,800 mortgage at 7% over the course of 30 years. You could reduce your interest expense to $460,292 when you buy your rate down to 6.75%. That's a gross savings of $20,735 and a net savings of $17,287 over the life of the loan.
Of course, these savings figures assume that you make minimum payments over the entire course of the loan. If you plan on paying your mortgage off early or selling your home before you pay it off, your points won't be quite as valuable.
How much would it cost to buy down a full percentage point?
Considering the fact that one mortgage point buys your mortgage rate down by 0.25%, if you want to buy down a full 1% on your mortgage rate, you'll need to purchase four points. Based on the example above, assuming a $344,800 mortgage, four discount points will cost you $13,792. So, how much money would that save you?
- 15-year mortgage: You would pay $213,049 in interest over the course of a 15-year $344,800 mortgage at 7%. A 6% rate would reduce your overall interest expense to $178,931 for a gross savings of $34,118. Considering the $13,792 cost of the points, that's a net savings of $20,326.
- 30-year mortgage: You'll pay a total of $481,027 in interest on a 30-year $344,800 mortgage at 7%. If you buy your rate down to 6%, your total interest will fall to $399,410 for a gross savings of $81,617. Considering the cost of the points needed to buy your interest rate down, your net savings would be $67,825.
Is it worth it to buy down mortgage interest?
"Especially in today's higher rate environment, buying discount points - sometimes called a rate buydown - deserves a look for homebuyers who plan to stay in the home long-term," says Eileen Tu, VP of Product Development for Rocket Mortgage.
However, there are some times when a rate buydown doesn't make sense. Tu says that in order "to decide if a buydown is worthwhile, it is important to determine the breakeven point. To do this, the homebuyer would divide the cost of the points by the amount of savings each month. The result would be the number of months it would take to recoup the upfront cost of lowering the interest rate."
Buying points is generally worth it in the long term, but "if someone thinks there is a chance they'll sell the home or refinance before" they break even, "a buydown would not make sense," she says.
The bottom line
Buying points is a compelling way to save on your mortgage, but only if you plan on staying in your new home long enough to recuperate the costs. However, if your new home is a stepping stone you only plan on owning for a few years, or one you plan on paying off quickly, it may be more advantageous to pay higher mortgage rates than to absorb the up-front cost of discount points.
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