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One of the many economic effects of COVID-19 is that interest rates on mortgages have dropped to record low levels—presenting a money-saving opportunity for those fortunate enough to be in a position to buy or refinance a home.
But there’s another way to get a lower interest rate—for a price.
Purchasing mortgage points, also known as “buying down the rate,” is a strategy that involves paying additional money upfront at closing in order to shave down the interest rate of your loan.
Generally, buying mortgage points is only worth your while if you plan to stay in your home for several years, usually at least six. Beyond that, it’s a matter of balancing priorities. Would you rather spend that money upfront to buy down your rate, or does it make more sense to put down a larger down payment—or even sock that money away into your 401(k) account?
Here are the things to consider when evaluating mortgage points.
What Are Mortgage Points?
Lenders offer mortgage points, also known as discount points, when you apply for a mortgage. Mortgage points are paid to the lender at your closing in exchange for a lower interest rate. Lenders also refer to mortgage points as “buying down the rate.”
Choosing to take points on a mortgage is completely optional, but it is one way to lower your overall interest rate and your monthly payment. Most lenders let you purchase between one and three points (sometimes less, sometimes more) which you pay upfront as part of your closing costs. One point equals 1% of your mortgage, or $1,000 for every $100,000. The monthly savings that result will depend on the interest rate, how much you borrow, and the term of the loan.
The length of time you plan to be in the home is crucial to your calculations. It typically takes a borrower between 4-6 years to recoup the cost from paying discount points at closing, says David Reischer, a real estate attorney at LegalAdvice.com, an online legal consultation tool.
Keep in mind mortgage points are usually only used for fixed-rate loans. They are available for adjustable-rate mortgages (ARMs), but they only lower your rate for your introductory period until the rate adjusts, which does not make the investment worth it.
How Mortgage Points Work
The table below will show you just how much points cost, how much you can save, the discount you could see on your rate, and how long it takes to break even using the example of a 30-year, 3.53% rate, and $250,000 loan.
30-Year Fixed, $250,000 Loan
|Points||APR (Before discount)||APR (with 0.25% discount per point)||Points Cost (1 point=1% of loan)||Monthly Payment (principal plus interest)||Savings Per Month||Break Even – Number of Months|
*Rates above based on NextAdvisor’s June 2020 rates
As you can see, investing $5,000 upfront to buy down two points will reduce your rate from 3.53% to 3.03%, saving you $68 on monthly mortgage payments. Once your $5,000 is paid back after about six years, you will start to see savings. In this example, a savings of $68 per month can turn into $816 saved per year, and $8,160 saved on your loan over the following 10 years. Between the break-even point and the end of the 30-year term, the savings would ultimately add up to about $19,000.
The catch: you’ll need the discipline to actually put away the $68 you saved each month.
Run the numbers to see how much mortgage points could save you—and whether that money would be better spent (or invested) elsewhere.
Alternatives to Purchase Points
Maybe you don’t have the upfront cash on hand to pay mortgage points at closing. Or, you’re not certain you’ll stay in your home long enough to break even. Although a point lowers your interest rate by 0.25%, there may be alternatives that will give you a better return on your investment. Let’s take a look at what else you can do with $5,000.
High-Yield Savings Accounts
High-yield savings accounts have few overhead costs, you can access your cash whenever you need it, and you can earn fairly high-interest rates at many online banks. As of July 2020, you can find accounts paying above 1.05%. Suppose you took $5,000 used in the example above and put it in a high-yield savings with a 1.05% interest rate. Assuming the rate does not change, you would earn $525 over 10 years, or $1,840 over 30 years.
Certificates of Deposit
CDs are relatively risk-free investments offering higher yields than some other low-risk investments. For example, you can invest $5,000 in a CD with an APY of 1.10%. Rather than buying two points for $5,000 at closing, you’ll earn a total of about $64 per year with your CD. After 30 years, your investment would equal $6,942 (deposit plus interest). That’s assuming APY on CDs stays at 1.10%, and you make no additional deposits into your CD during that period.
Thomas Jefferson once said, “With great risk comes great reward.” And, when it comes to investments, that may be true. You won’t “get rich quick” with most investments, but rather grow your money over time. There is also the risk you’ll lose your money if not invested wisely. The most commonly recommended way to put your money into the stock market via a retirement account such as a 401(k) or Roth IRA. You’ll have to have the stomach to withstand the highs and lows and be in for the long run to see a healthy return.
The average annual return with a 401(k) is between 5% and 8%. This, of course, depends on the markets and which investments you choose. Let’s say you invested $5,000 in a 401(k), with a 6% rate of return. By year 30 you could be looking at a $28,000 balance.
Shorter Term Loans
“An alternative to paying points to buy the rate down is to consider shorter-term loan programs,” says Eric Jeanette, owner of Dream Home Financing and FHA Lenders, online education sites that offer solutions in various mortgage programs and lending alternatives. “These mortgages often come with lower interest rates, and if you are not planning to stay in your home for a long time, you may be able to get a mortgage at a lower rate without paying points.”
For example, a 15-year fixed APY is around 3.01% compared to a 30-year fixed APY of 3.42%. You can see a difference of 0.41%, which is comparable to buying two points off the 30-year 3.43% rate. Instead of spending $5,000 to see the same rate reduction, you could opt for the 15-year instead of the 30-year. Yes, your monthly payments will be higher since you’re paying your principal over a shorter-term. But, you will pay less in out-of-pocket interest without having to buy it with points.
Make a Higher Down Payment
“The purpose of paying mortgage points is to pay a lump sum upfront to lower your future monthly payments,” says Caleb Liu, owner of House Simply Sold, an L.A. based real estate solutions service. “You can achieve a similar, although not equal result by redirecting the amount earmarked for mortgage points toward a slightly higher down payment. The needle won’t look like it’s moving much, but the difference is your down payment is equity and fully recoverable at the time of sale, whereas mortgage points are an expense and not recoverable.”
Are Discount Points Worth it?
“Generally, buying mortgage points is the most beneficial when you can comfortably afford them and plan to stay in your home for a long period of time,” says Baruch Silvermann, CEO and founder of The Smart Investor, an online investment education site.
It’s also worth noting mortgage points are tax-deductible if you meet the IRS requirements.
Finally, note that buying a home means setting yourself up for the bevy of expenses that come with owning a property, from taxes to repairs. You’ll need to have enough cash to make a down payment, cover closing costs (which can equal 2 to 5% of your purchase price) and have enough savings leftover to get you through any emergencies or loss of income. If purchasing points leaves you without sufficient savings, it may be a risky proposition.
Before you decide, compare your options with other investment opportunities. We find investing in your retirement and 401(k) can see the best rewards. The compound interest on $5,000 does not come with any strings attached compared to buying points. Meaning, it’s not dependent on whether or not you move, refinance, or have the discipline to save the $68 difference each month. It is a set-it-and-forget-it approach.
To decide for yourself if mortgage points are worth it, ask yourself if you can afford the cost of and all other closing costs. Determine if you’re planning to be in your home long enough to recoup the cost of mortgage points. Only then will you feel confident to decide if discount points are worth it.
This article was updated on Sept. 4, 2020, to remove comments made by a source whose credentials do not meet NextAdvisor editorial standards.