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Are you considering making a house purchase and want to pay the least possible interest rate on your home loan? What do you know about mortgage points?
Many people, especially first-time homebuyers, don’t know that you can leverage mortgage points to reduce the interest rate on a home loan. These are the upfront fees paid in order to allow for reduced interest rates and as a result lower monthly payments. One mortgage point equates to 1% of the loan amount. So, if you are taking a $300K loan, a single point is worth $3000.
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Mortgage points provide a way to save money in the long run as you pay more upfront. However, it is a route that is not meant for everyone, and there is a lot to consider to determine whether this is the right financial decision given your situation. If you are pondering if it is in your best interest to use mortgage points, you may want to read on and also get in touch with a reputable financial advisor. This way, you will learn more about the effect of a mortgage on your long-term financial goals.
What are Mortgage Points?
Also referred to as discount points, mortgage points are the upfront payments made during the closing of a home loan with the aim of reducing the interest rate, and consequently, the monthly payments. This is primarily why it’s known as buying down the rate.
Buying mortgage points can reduce the amount of money you have to pay the lending institution. With the reduced interest rate as well as monthly payments, you should, on paper, be able to pay the loan sooner.
The Different Types of Mortgage Points
As a first time home buyer, you must know there are two types of mortgage points:
Origination Points- These refer to the costs related to mortgage processing. The lender charges you fees for loan processing and so, you can consider them as part of closing costs.
Discount Points- Essentially these are mortgage points. The more you purchase, the lower the interest rate. There’s no universal framework as every lending institution is different in how they operate, particularly how they determine reduced interest rates in proportion to discount points.
In simple terms, the max amount of interest rate cut comes down to the terms set by the financial institution, the kind of loan, and the real estate market. On average, you can reduce your interest rate by anywhere between 0.12% and 0.25%.
Calculating Mortgage Points
Let us assume you are securing a fixed-rate home loan of $200K for a period of 3 decades. Your lender’s interest rate is 5.5%, meaning you have to make a monthly payment of around $1136.
So, you decide to leverage discount points, where each point equals 1 percent of the mortgage, and settle for two points for a total of $4000. This will result in an interest rate reduction of 0.5% and thus 5%. With a 2 mortgage points purchase, you will have to pay $1074 per month for the loan. This deduction from $1136 equates to a $62 saving per month.
To determine how long it will take to recoup that investment or break even, simply divide the amount of money you’ve paid for purchasing the discount points by the savings you’ve made. It comes to 64 and a half months. Simply put, you will begin saving money after 5.5 years as long as you stay in the same property for this period.
It is important to note that the example presented above is extremely simplified as we did not factor in other associated costs like property taxes, homeowners insurance, etc.
Should You Buy Mortgage Points?
Whether you should get discount points or not all boils down to saving money. If you have the money you can afford to put towards mortgage points, then it is a good idea to purchase them as it will help reduce your payments. This particularly comes in handy when the property seller is willing to bear some of the closing costs. Discount points are usually part of the seller-paid costs and so, if you decide to pay them yourself, they should be tax-deductible.
When it comes to property refinancing, chances are the closing costs will be a part of the new mortgage. If you have sufficient equity in your house to not worry about the increased cost, you should leverage discount points. Then you can have them included as part of the new mortgage to reduce your monthly payment without having to pay anything out of your pocket.
If you intend to live in that house for several years, it makes sense to purchase discount points. Without proper calculations, however, it may not seem financially viable.
For example, saving $20 on your monthly payment means you’ll begin to save money from the 9th year. A reduced interest rate also implies you will not have to refinance down the road. Keep in mind that there are costs associated with house refinancing. That’s why it makes financial sense to purchase discount points in order to get the best deal in a low-interest-rate environment. In such a case, there will not be a need to refinance your mortgage.
In a high-interest rate environment, however, you’re better off without purchasing mortgage points. That’s because mortgage interest rates are bound to reduce down the line providing a chance to refinance at a lower rate before you can fully leverage the discount points.
Is It Worth Paying for Mortgage Points?
As a first time home buyer, if you do not have adequate money to make a substantial down payment, it is advisable to take the home loan at the prevailing rate and consider refinancing down the line. Refinancing is simply securing a new loan to pay off the existing one at a better interest rate as well as terms.
Mortgage refinancing makes financial sense when you’re up to date with your payments and have therefore built up significant equity in your property as well as improved credit score. If you have a substantial amount saved and can afford to make extra payments, however, it’s advisable to purchase discount points.
At the end of the day, it makes financial sense to purchase discount points, as a first time home buyer, if you plan to stay in that property for the foreseeable future and have enough money to make the additional payments. Regardless, it is advisable to do the necessary calculations to ensure the discount points are worth it. This is where a seasoned local financial advisor comes in handy.
What You Need to Know About Origination Fees
Most, if not all lending organizations include an origination fee in their quotes. For you to get a no-point loan, they are required to disclose a 1% fee and then give a 1% rebate. This seems counterintuitive, but the Dodd-Frank Act, specifically the disclosure laws are the reason behind this. If lending or financing institutions don’t disclose the fees from the onset, they do not have the legal basis to tack on the fee down the loan. If they disclose the loan estimate without locking the terms and don’t reveal an origination fee, then they won’t have a choice but to lend the money based on those terms.
It might seem like a good thing, but when you apply for a loan and the rates go up during the processing period, you may have to take the loan at a higher rate. Here’s an example to make things clear:
If the interest rate was 4.5% during application but it increased when you got approved, you have two options. The first is to take the loan at a 4.625% interest rate or 4.5% with an extra cost of 0.25% or ¼ of a point. If the quote provided doesn’t come with origination charges, you will not be eligible for the second option and will have no option but to settle for the higher interest rate.
The Bottom Line
Whether mortgage points are worth your money all comes down to your personal situation, when you are a first time home buyer. Consider using a home loan calculator to determine the effect of purchasing or not purchasing discount points in the long run. In addition, it is imperative to ensure you’ll be able to afford the monthly home loan payments.
Tips for A First Time Home Buyer
If you’re a first time home buyer, consider partnering with a financial advisor for the financial aspect. Purchasing a home, as mentioned at the beginning of this read is a substantial investment following a big decision. Finding a good financial advisor should not be a daunting task as there are many qualified and experienced out there. There are free tools on the internet that should easily match you with the available financial advisors in your area.
Before shopping for a house, ensure that the price is within your budget. You can use a tool like the SmartAsset calculator to determine how much you can afford to spend on the property. Parameters to include are credit score, annual income, location, marital status, and credit score.