Discount Points: Should You Pay Them?

Even with interest rates at historic lows - I have been asked the question more than once lately “should I buy the rate down even lower?”

My answer - “It depends.”

Discount Points - How They Work

The simplest way to describe a discount point is “you give the bank money and they give you a lower rate.” As a consumer, you pay a dollar amount up-front and in exchange, you get a lower interest rate.  How much you pay up front and how much lower the rate that you get is somewhat negotiable.  I use “somewhat” because it really does depend on a number of factors - and the factors usually change all of the time… but in general, there is a simple rule-of-thumb to use when paying discount points.

Discount Points - A Simple Rule of Thumb

While not *exactly* accurate, the general rule of thumb is that for every 1% of the loan amount - or every 1 discount point that is paid up front, the rate will drop .25%.

So as an example, if the par rate were 5% for a 30 year fixed rate mortgage on a $200,000 loan, if you wanted to get a 4.75% rate, it would cost roughly 1 discount point or $2,000 up front.

Using the above example $200,000 loan, if you paid one discount point, here is what the math would look like:

$200,000 x 5% = $1,073.64 monthly payment

$200,000 x 4.75% = 1,043.29 monthly payment

Difference in monthly payment = $30.35 each month or $364.20/year

Break-even = around 6 years.

Discount Points - When They Make Sense

In the above example, it would possibly make sense to pay a discount point and buy the rate down if you planned on having the loan longer than 6 years.

Generally speaking, the longer that you plan to have the loan, the more sense it may make to buy the rate down.  If you are moving into the home of your dreams and planning on staying there for 30 years - then it may be a wise option to pay a discount point - or maybe even two!

Discount Points - When They Make THE MOST Sense

One often overlooked item when negotiating for a new home is the fact that in a buyers market, you can often times get the seller to pay at least one discount point to buy your rate down! If you can possibly get the seller to pay a discount point to buy your rate down, this is when paying a discount point makes the most sense of all — it is “free” to you and it will help lower your mortgage payment by hundreds of dollars each year!

Be extremely careful when paying discount points - you want to make sure that the money that you are paying is actually going towards buying the rate down.  You also want to make sure that you do your homework as to whether or not it makes sense to pay discount points - and using our simple rule-of-thumb will help!

January 12, 2009