My good friend and colleague, Mike Nelson, has put together a fantastic piece on understanding the pros and cons of paying discount “points” or fees to obtain a lower interest rate. I’ll warn you, this is some real “inside baseball” type of stuff (and as Mike states, “I recommend this blog and a smart phone as you try to go to sleep…if you have insomnia”), but he does a fantastic job of highlighting the key reasons to either buy down your rate, or not.
Source – Mike Nelson’s Efficient Selling Blog
Let’s start at the beginning – with a definition. This definition comes to us from Investopedia along with an article they penned on the topic.
Discount points are a type of fee mortgage borrowers can purchase that lowers the amount of interest they will have to pay on subsequent payments. Each point generally costs 1% of the total loan amount and depending on the borrower, each point lowers your interest rate by one-eighth to one one-quarter of your interest rate. Discount points are tax deductible in the year in which they are paid.
How long the customer stays in the house or re-finances ultimately determines if a discount is worth the cost!
Most borrowers and lenders will immediately conduct a break-even analysis to determine the benefit of the discount. In Mike’s example, the $10 difference in monthly payment is recouped in 100 months, or 8.4 years. The borrower then considers how long they will live in the house – if it’s more than 8 years, the discount seems like a good deal. Do click on Mike’s link to find out more.
The average 30 year mortgage in the US is refinanced every 7 years.
So what is the conclusion?
Generally, if the borrower believes they will be in the house more than 10 years they should give strong consideration to paying the discount on the rate with cash and not financing into the mortgage. After 10 to 15 years the discounted interest rate is generally better for the borrower. Interestingly, however, the average loan is refinanced every 7 years, so take that into consideration, as well!
One other thing to factor in, are the tax ramifications to the mortgage. It’s important to consult with a financial advisor or CPA for the complete tax implications.
Work with a lender who can do the math!
If you are working with a lender that does not understand these concepts, you are working with the wrong lender! It’s the responsibility of the lender to calculate the implications of discounts and pass that on to you.
Finally, remember this: lenders are not giving discounts because they save you money at their expense. The lenders (or at least the one’s who are doing it right) are doing sophisticated calculations determining the risk of discounting rates over the lifespan of an entire portfolio of loans. Lenders will price accordingly – just make sure you as a borrower have don the analysis to know which scenario is best for your situation!