The Truth about Discount Points: Are They Really Advantageous?

Not too long ago, we wrote a blog post discussing how discount points can lower mortgage payments. Now, we go one step further and talk about the advantages and disadvantages of discount points.

Since the introduction of mortgages, borrowers have been searching for a way to decrease their overall mortgage payments. Though purchasing discount points will lower the interest rate on a home loan, they don’t always translate into more affordable monthly mortgage payments and savings for the borrower.

The truth is that discount points were created for the benefit of the lender, not the borrower. However, there are several advantages for borrowers as well. Let’s take a look at them.

Lower interest rates
When buying discount points, borrowers actually prepay interest on their loans. Since lenders don’t have to wait several years to collect their interest earnings, they’ll charge lower rates. Generally, every discount point will reduce the interest rate by 0.125 to 0.25 percent. Homebuyers are allowed to buy discount points on almost any type of loan, including FHA- and VA-guaranteed loans. A lower rate will also allow a borrower to pay down his mortgage sooner; however, this is something that should be considered in relation to the savings resulting from the points.

Lower monthly payments
Lower interest will result not only in discounted interest rates over the mortgage term but also in reduced monthly payments. While borrowers are required to pay for discount points at the closing, the interest and monthly payments will be reduced over the entire life of the loan.

Tax deduction
Mortgage discount points are a form of prepaid interest. This means they can be deducted when filing taxes for the year in which they’re paid. In addition, discount points allow borrowers to get a tax deduction when refinancing, getting an equity loan or opening a line of credit. For more information on the deductibility of discount points, please visit the IRS’ Topic 504 – Home Mortgage Points.

Coming down to the disadvantages of buying discount points, below are a few essential aspects a borrower should pay attention to.

Break-even period
If a homebuyer plans on selling the house within the next four or five years, he will lose the savings resulting from the reduction in the interest rate paid in advance. For instance, if a borrower buys 2 points on a 30-year, $400,000 mortgage to reduce the interest rate from 4.5 percent to 4 percent, it will take more than 5.5 years (break-even period) to recoup the money spent on the points. If he refinances or moves before the break-even point, he won’t get any benefit from the points paid at the closing. Depending on how soon a homebuyer refinances or moves out, he may lose a lot of money.

Decreasing interest rates
Sometimes, interest rates go below the rate provided by the lender with discount points. When this happens, the value of the points paid by the borrower are worthless.

Up-front costs
Many borrowers overlook an important aspect: discount points are typically paid up front, at the closing. Considering the aforementioned example, a borrower must pay $8,000 to buy 2 points on a $400,000 home loan. For someone who sits on cash, paying points in advance may not be an issue; for a homebuyer who doesn’t have extra cash, the cost of points can be rolled into the loan, but this alternative is subject to limitations.

At North Florida Mortgage, our knowledgeable and experienced mortgage consultants are ready to provide additional information on discount points and assist homebuyers with the mortgage application process.

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