What are mortgage points?
When you get a mortgage, the lender might give you the option of paying discount points at closing. A discount point is a fee you pay to reduce the interest rate on your mortgage. The transaction often is called “buying down the rate.”
How much does a point reduce the rate?
When you pay one point, it means that you pay a fee of 1% of the mortgage amount. Typically, when you pay one discount point, the lender cuts the interest rate by 0.25%. But one point can reduce the rate more or less than that. There’s no set amount for how much a discount point will reduce the rate. The effect of a discount point varies by the lender, type of loan and prevailing rates, as mortgage rates fluctuate daily.
On top of that, “paying points” doesn’t always mean paying exactly 1% of the loan amount. For example, you might be able to pay half a point, or 0.5% of the loan amount. That typically would reduce the interest rate by 0.125%. Or you might be given the option of paying one-and-a-half points or two points to cut the interest rate more.
How do discount points affect payments?
Paying points reduces the interest rate and therefore the monthly payments. The monthly savings depends on the interest rate, the amount borrowed and the loan’s term (whether it’s a 30-year or 15-year loan, for example).
The table below illustrates the monthly savings from paying one or two discount points on a $200,000 mortgage with a base interest rate of 5% and a 30-year term. Without discount points, the monthly principal and interest is $1,073.64. The monthly payments are lower after reducing the rate by paying one or two basis points.
When should you buy points?
If you can afford them, then the decision whether to pay points comes down to whether you will keep the mortgage past the “break-even point.”
The concept of the break-even point is simple: When the accumulated monthly savings equal the upfront fee, you’ve hit the break-even point. After that, you come out ahead. But if you sell the home or refinance the mortgage before hitting break-even, you lose money on the discount points you paid.
The break-even point varies, depending on loan size, interest rate and term. It’s usually more than just a few years. Once you guess how long you’ll live in the home, you can calculate when you’ll break even.
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