Does it ever make sense to pay discount points? Depending on the situation, it can sometimes make sense to pay discount points in order to “buy the rate down” even lower than rates currently are.
Discount Points – How They Work
Discount points are paid in order to “buy down” an interest rate from the par value. In the simplest description possible – the way discount points work is that you give the lender a set amount of money up front in exchange for a lower interest rate than they would give you otherwise.
How much money do you need to pay up front in order to get a lower rate? It is never really a set amount – it is negotiable for each individual lender. Because the cost in order to buy down a rate is different between lenders and even different from day to day, it can sometimes be confusing to know “if you pay X in discount points, the rate goes down by Y.”
Discount Points – A Simple Rule of Thumb
A simple rule of thumb when paying discount points is that for every 1 discount point that you pay, the rate will go down by .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.
When Does It Make Sense To Pay Discount Points?
It can make sense to pay discount points when you plan on keeping the loan longer than the break-even point (in years) that you calculated in the above break-even formula.
So using the above example, it may make sense to pay discount points to buy the rate down if you were planning 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
In my opinion, one thing that is overlooked by many agents and borrowers in today’s market is the chance to have the seller actually pay to buy down your interest rate. Yes, it is possible that the seller can pay your discount points – which will in turn result in a lower rate for you for years to come.
Discount points make the most sense when they are “free” to you because the seller is paying!
By using our simple rule of thumb (1 discount point = .25% lower rate), you can be well-prepared when negotiating with the sellers of the house that you want to buy… and remember, you are 100% guaranteed to get a NO answer if you don’t ask, so be sure to ask the seller to pay at least one discount point!