If you're looking for a new mortgage when buying or refinancing a home, a pressing question is whether to pay points to the lender. Mortgage discount points are extra fees a lender charges to set a home loan at a certain interest rate. The amount of money you pay in extra points could be significant, so it's important to determine the potential return or payback of those points. Your personal finances and future plans are the most important factors in whether or not you should pay the points.
Rates and Points
Lenders offer different interest rates with a range of discount points. For example, the lender may provide a 6.0 percent loan with zero points, a 5.75 percent loan at one point, or a 5.5 percent loan if you pay two points. One point is one percent of the loan amount — one point on a $150,000 loan would be $1,500. Paying discount points is often referred to as "buying down the rate."
Convert Rates to Payments
To determine if paying points makes financial sense, you need to calculate the monthly mortgage payments for the different rate and point combinations. You can ask the lending officer to calculate the payments for you or plug the rates into an online mortgage calculator. For example, a $150,000 30-year loan at 6 percent would have a monthly principal and interest payment of $899. Buying the rate down to 5.5 percent gives a payment of $852. Buying the rate down in this case results in a monthly savings of $47.
Calculate Payback Period
With the monthly savings from paying discount points for a lower rate, you can calculate how long it would take to earn back the cost of the points using simple division. If paying two points on a $150,000 loan costs $3,000 and the monthly savings is $47, it would take 64 months to earn back the points with the lower payment. With this example, if you plan to stay in the home for longer than five years, paying the points could make financial sense. If you plan to sell the home in a couple of years, you're better off going with the zero points and higher rate.
Paying points to get a lower payment may make it easier to qualify for a loan based on your income. Lenders have strict payment-to-income ratios, and using points for a lower rate could bring your payment in line with the lender's requirements — assuming you have the cash to pay the points. It is important to remember that refinancing the loan before the points payback period means you lose some of the benefit of buying down the rate. If you do not have the excess cash to pay points, look at the zero-points rates and payments and see if the higher mortgage payment works within your budget.
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