Everyone wants the lowest interest they can get for a mortgage. But are you willing to pay to lower that rate with a lump sum in the beginning of the mortgage? That’s what discount points are all about.
What are Discount Points?
Discount points are a form of prepaid interest because you put down more upfront money during the loan closing process. Each discount point equals one percent of the loan amount. This type of mortgage point lowers the amount of interest you pay for the rest of the loan term.
Tax Deductible Mortgage Discount Points
The good news is that discount points could be tax deductible according to the Consumer Financial Protection Bureau. The IRS considers discount points as prepaid mortgage interest, which means you might be able to deduct some or all of your points. It all depends on your overall financial circumstances. But that still means you need to come up with more money at your closing to pay mortgage discount points. So does that really help out your situation? Read on.
Lenders Must Use Discount Fees to Lower Your Rate
Most lending institutions have a maximum amount of discount points you can buy – usually three or four. With all the new rules and regulations placed upon mortgage lenders, one of them states they can no longer make money on the amount of points sold. In other words, every penny you pay for discount points must be used to directly lower your rate. That’s great for consumers.
Discount Points a Waste of Money?
Your costs for discount points can vary depending on the cost of the house and the interest rate. Paying points can only make sense if you actually will be saving money. But for now and in the coming months until interest rates go up, discount points really are not a good idea, says Scott Williamson, senior vice president and mortgage loan officer at West Gate Bank in Lincoln, Neb.
“It doesn’t make financial sense right now when interest rates are so low,” he says. “It’s just where the market has been. Obviously if the pay back is there, it’s something to look at in the future. For now, put the money you would have paid for discount points into the stock market or in a money market account. You will come out far ahead.”
Mortgage Discount Point Calculation
Typically, one point is considered to be equal to one percent of your total loan. Williamson gives an example of how a discount point works.
Let’s say you are considering a $200,000 loan with a 20 percent down payment and a 4 percent interest rate loan. A point on this loan would cost about $2,000. To buy the rate down just a quarter of a percentage to 3.75 percent, it would cost you 2 points or $4,000.
“Your monthly principal and interest without the points would be $954. With the points, it would be $926. That means it cost you $4,000 to gain a $28 advantage each month,” he says. “It will be 142 months or about 12 years to recoup that $4,000.”
When Should You Opt for Discount Points?
Williamson says that if you can’t get your return on your investment in three or four years at most, then don’t buy discount points.
In the 1980s and 1990s when interest rates were at 10-18 percent, buying points made sense and you could recoup your money very quickly.
“It’s been very rare paying points to buy a rate down in the last 10 years,” Williamson says. “We’ve sustained a declined interest rate market for quite a few years now, and that is rare. The economy is still struggling.”
He adds that the interest rates need to go up to make the housing market strong. But the feds want to keep the rates down so it doesn’t impede people from buying homes.
“There will be a time when the economy can sustain increasing interest rates. People want to see return on investment in money market accounts and certificate of deposits. There haven’t been good rates on those for a while. When we do see that, that will signal a better economy,” he says.
When he started in the lending business in 1982, the interest rates for homes ran between 16 and 18 percent.
“That was a tough time. Houses weren’t selling, builders went belly up,” he says. “A few generations have no recollection of that. It’s funny to talk to young borrowers who come in and think 5 percent is the end of the world.”
The low interest rates have stagnated the housing sales market, he says. Lot of people are staying in their homes longer and not moving or refinancing. They are locking themselves in and not moving for a while because they don’t want to lose the low interest rate.
“Points right now are not a wise use of your money. You have to look at what is the return on your investment and how long it will take to recoup that money,” he says.
Check Today’s Rates and Discount Points
While mortgage discount points are not often a good idea in today’s market, it’s still wise to check your options. Get a free rate quote here, with and without discount points, then calculate your payback period. You might be glad you checked.