I was fortunate to be able to buy my current home in late 2020, when interest rates were insanely low. As home values in my neighborhood increase along with the interest rates, it's highly possible new people moving into my neighborhood will pay over $2,000 more per month than my family is for the same type of home.
In trying to avoid these rate increases, potential homebuyers are increasingly looking for ways to save costs. We've covered one of these ways in our video on Adjustable Rate Mortgages, and now I'd like to cover another popular strategy: using discount points to "buy down" a mortgage rate.
What Is A Discount Point?
A "point" equals 1% of the loan balance. For this post, we'll be using a $300,000 loan to illustrate certain concepts, so a single point would equal $3,000 ($300,000 x 1%). A "discount point" allows potential homeowners to pay an upfront fee in exchange for their lender lowering the loan interest rate, which increases the costs they must pay at closing The points are reflected on your Loan Estimate and also your Closing Disclosure, and your lender should walk you through the difference between a loan rate paid down with points versus a "zero point" loan (i.e., a loan whose rate isn't paid down with discount points). The amount it lowers the rate can depend on a number of factors, such as your specific lender, the general market, and the type of loan product you're using.
Are Discount Points A Good Idea?
To understand the pros and cons of discount points, you must first understand a concept called amortization. Amortization is defined as the action or process of reducing or paying off a debt with regular payments. In layman's terms, you are amortizing your mortgage loan over a predetermined length of time when you make fixed monthly payments. When you're amortizing a loan, the two variables that determine your fixed payment are the loan's interest rate and repayment period. These two variables dictate the monthly payment that will be needed to pay off the loan's principal and interest by the end of the period.
Early in the repayment process, the monthly payment will primarily cover the growing interest, with a smaller amount going to pay down the principal. With each passing month the interest rate will stay the same, but is calculated off of a smaller principal balance. This lower balance means less accrued interest, and an increasing portion of your fixed payment will go towards the principal. This snowball effect picks up momentum as time goes on, and towards the end of your repayment, almost all of your payment will go towards the principal.
For illustration purposes, I've gone to a well-known site, Bankrate.com, to calculate what the monthly payment would be for a $300,000 home loan at 4.25%.
You can see that at $300,000 principal plus interest of 4.25%, a monthly payment of $1,476 is needed to pay the loan off in full by the end of the 30 year repayment. You can also see that at the 4.25% rate, it would take $531,295 to pay off what started as a $300,000 loan.
This total payoff amount, which far exceeds the original loan principal, is what can make buying down your mortgage rate using discount points look like an attractive option. Why? Because even a seemingly small decrease in the loan interest rate can sometimes lead to a significant reduction in the total cost of the loan.
If we use this same $300,000 principal and lower the rate from 4.25% to 4%, you can see that the total loan cost is now $515,609, a savings of around $15,000 over the course of 30 years.
One would think then, that the only determining factor in choosing to buy down your mortgage rate is whether the total payments towards the higher interest loan exceeds the cost of buying down to the lower rate. Using our example with this logic, any cost to buy the rate down to 4% is worth it as long as it's less than the extra $15,000 needed to pay off the loan at 4.25%.
But it's a more involved decision than that, and in order to know what's best for you, you'll have to consider two variables – the Breakeven Point and Time Value of Money – and also know how to read and amortization table.
Let's start with the two variables:
Time Value of Money
According to Investopedia, "the time value of money is the concept that a sum of money is worth now in the same song will be at a future date due to its earning potential." Simply put, giving you $$15,000 today is more valuable than giving it to you five years from now, due to the fact that handing it over now allows you to put it to use and hopefully let it grow. When you are estimating to what amount this money can grow if you were to receive it now and invest the proceeds, their calculations you can use to determine the money's Future Value.
We used a Future Value calculator at Calculator.net to determine the future value of a $10,000 sum earning a return of 4% over a 30 year period. You can see that by the end of the 30th year, the future value is $32,433 a gain of just over $$22,000
The example we've been covering for our mortgage calculations – $300,000 at 4.25%, or the same amount at 4% – led to a difference in repayment cost of just over $15,000. If our potential homeowner were offered the opportunity to buy down there rate to 4% for a cost of $10,000, they might think they are making the right decision; $10,000 in discount payments save them $15,000 over the course of the loan. But in doing so, our future value calculator suggests they'd be sacrificing over $22,000 in potential market gains even at a conservative interest rate. Our homeowner has to consider what they value more when making their decision. And they can gather even more information prior to making the decision by using an amortization schedule to discover the second variable.
Put simply, the breakeven point is the month where you first experience the financial benefit of paying down the rate.
Let's assume homeowner decided to pay two points to buy down their rate to 4%, which would cost them $6,000 ($300,000 loan x 2%)
There are two ways to look at the Breakeven Point. Some may consider the breakeven point to be the first month the savings from your lower payment exceed the costs of paying down the loan. As an example, if you paid $6,000 in points to secure a mortgage that saves you $100,month, your breakeven point would be the 61st month (61 monthly payments x $100 payment savings =$6,100 total savings).
Others consider breakeven point in our example as the date the mortgage balance of the 4% loan is at least $6,000 lower than what the balance of the 4.25% loan would have been in the same month.
While there are lenders who will calculate your breakeven point for you, it's best if you know how to read and amortization schedule so you can find the date for yourself.
An amortization schedule is a table that shows the month-to-month effects your mortgage payment has in terms of the interest accrued, principal repaid, and ending loan balance.
Using the same data from Bankrate (we downloaded the amortization schedule as a CSV file), at 4.25%, our first $1,475 monthly payment sees $1,062 go just towards interest, while only $413 of the principal is repaid, lowering our initial $300,000 balance to $299,586.
In the second month, our payment is the same, but the 4.25% is now accruing against a lower number, $299,586. This means that less interest is accruing, and (slightly) more of our fixed payment is going towards the principal.
Switching to the amortization table for our 4% loan, you can see that the monthly payment is lower, because it takes less money to pay off the loan by the end of 30 years. But even with a lower payment, the lower interest means that a larger portion of the principal is being covered from the very first month.
This gap will only widen with time, and eventually, you'll be able to find the month in the schedule where the breakeven point makes the cost of buying down your rate worth it.
But there are other scenarios to consider as well. Things aren't as black and white as the Time Value of Money and Breakeven Point. Even if you plan to leave before you break even, there is the possibility that you just prefer the lower payment that comes with a discounted mortgage, even if it means paying an upfront sum. You could have other expenses that have less wriggle room, and want to make sure your monthly budget stays balanced. Remember that nothing happens in a vacuum. Anything you do in one area of your finances will likely affect multiple other areas.
For those with significant debts, there is also the possibility they need to buy down their mortgage to get within the allowable debt to income range their lender will approve for their loan. In this scenario, the breakeven point is irrelevant, as they wouldn't be approved for the loan with the higher rate and payment in the first place.
At the end of the day, it's up to you to use this knowledge and determine which factors are most pressing in deciding whether you should utilize discount points, but I wanted you to have the knowledge in the first place. And hopefully, this little post helped in doing so! Happy house hunting!