Today, we’ll go over discount points. We’ll examine what exactly are discount points on a mortgage loan. I’ll show you how to calculate them and if you should pay them or if they make financial sense in your specific scenario.
What are discount points? We get a rate sheet when we price your loan as a loan broker or when a lender does it. The rate sheet is determined by several factors: your credit score, the loan amount, your location (your zip code is used to kind of get what county you’re in), and the loan to value. Again, many different factors go into figuring out your rate. Every lender has different pricing, and pricing changes daily. Sometimes, it changes multiple times a day. It’s a spur of the moment.
Your interest rate comes on a grid, like an excel sheet that gives us multiple options. It’ll show your rate and the price for the rate. If you’re at par, there’s no fee to buy that interest rate, and there are no credits or incentives. When you’re at par, the lender’s not offering any rebate towards your closing costs. If there are discount points for the rate, you, as the borrower, have to pay a fee to buy that rate down.
If you’ve ever bought a car or leased a car, you’ll know that this is an option in the automobile industry. You can buy a car, and you might have zero percent APR for five years. However, if perhaps, you need to own it for six years, they might agree to do it at 2%. However, they might tell you that if you pay $2,000 upfront, it would be a zero percent loan. There are different ways to buy down the rate, which is what discount points do.
Limitations on Discount Points
There are some limitations to take note of. You can’t spend an infinite amount of money to buy your rate down. There’s a maximum amount of points you can spend on your loan. It’s set by government regulations, so there are points-and-fees tests that we need to do on every loan to make sure you’re there. However, generally speaking, if you ask your lender what your discount point options are, they’ll be able to explain to you. They will tell you how much money you need to buy a rate down. Conversely, they might also tell you that you can get lender credits if you don’t mind going a little higher on the rate.
How to Figure out if it Makes sense
How do you determine if it makes sense for you to buy down your interest rate? There’s a straightforward formula, and I’ve taken a real-life example from today’s rates. We’re going to check out some numbers; follow along, and you’ll see how simple the formula is. There are a couple of steps to it; however, once you know it, you’ll be able to make a perfectly informed decision on whether it makes sense for you to do it or not as a borrower.
Now, let’s get into the situation I already put together. Imagine somebody is purchasing a home in the Los Angeles area. Right now, homes in the LA area are costly, so we will use a low estimate of $800,000 for a single-family. I don’t know why houses are so expensive in Los Angeles; I think about moving to Texas almost every day. Now that we have our $800,000, imagine that the buyer has good credit and is coming down with 20%, which puts our loan at $640,000.
Note that your discount points are always based on your loan amount, not the purchase price.
At today’s rates, what I have, as a wholesale loan broker, I’m able to get 3.875% essentially at par, which means no discount points or lender credits. 3.75% has a discount point cost of $3,360. Now, that’s less than a true point. Just so you know, a percentage is usually equivalent to a point on a loan. It’s rarely a point; it’s usually three decimal places, which is thousandths of a point.
You can tell that this is much less than a whole point because, on a $640,000 loan, 1% would be $6400, which is a little around a half a point cost to buy the rate down 1/8%. So from 3.875% to 3.75%, there’s an additional cost of $3360 at today’s rates. Before deciding whether it makes sense for us to pay or not, let’s talk about how you can even pay your discount points.
How to Pay Discount Points
If you are purchasing the house, you really don’t have many options; you have to pay your discount points in cash. The only exception to this is if you’ll get a seller concession. When you’re buying a house and going through an inspection, you’ll see some mold or some damages that need repairs. You can negotiate for seller concessions, so if you get a $5,000 seller concession, they can be used to pay for your discount points. Discount points are part of closing costs, and generally speaking, seller concessions go towards closing costs, so you can do it that way on a purchase.
On a refinance, you can usually raise your loan amount. If you owe $640,000, but it’s on a million-dollar property, perhaps you’ve built up the equity because you’ve lived there for a while. Your loan amount ($640,000) includes closing costs, and you find out that you can buy the discount points of 3360; you can then raise your loan amount from $640,000 to $643,360 to cover the cost of lowering your rate.
These are your options in terms of how to pay for it. You can either pay for it in cash out of your pocket, just like anything in the world, you can pay for it through a seller concession, and you can pay for it by raising your loan amount. These are the three general ways you can pay for your discount points.
Now, we’re back to determine if it makes financial sense to do so. To calculate this, we need a little more information. We need to know the mortgage payment specifically on the two rates you’re considering. You don’t want to include your property tax and insurance because those will stay fixed; what you want to look at is the actual mortgage payment.
Back to our specific scenario, the 3.875% cost 2963.94 per month, and if we were to buy that discount point and go down to 3.75%, the monthly expense on your mortgage (your principal and interest) would be $2,942.28.
The biggest question now is what you’ll be saving. If you subtract $2,964 from $2,942.28, you get a savings of $21.74. This is the second number you need to note for the equation. The first number you need is how much the discount points are. In our case, the discount point will cost $3,360, and we will have savings of $21.74 a month.
Does this sound like it makes sense? We’re not done. Divide the equation to determine how many months it will take you to break even on that investment. We take $21.74, and we find out how many times it goes into $3,360. Hence, if you divide these numbers by each other, you get an answer of 154 times and a little over. This means that it will take you 154 months or around 13 years to break even on that investment. So, for your $3,360, you’re saving that extra $21.74 every month. You won’t see that make financial sense for 13 years.
Now, if you are planning on staying in that house forever and the interest rate is so low that you’re never going to refinance; let’s say you got a crazy deal at 2% when the rates were at rock bottom, then paying for discount points can make sense even at 13 years. However, I rarely recommend it.
As a loan broker, I often ask what the intention is of the borrower. If you plan to make this your forever home, buying discount points might make sense, as long as you can recoup it, usually within 5-7 years. I tend to say anything over this with the equation; I say it’s not the smartest investment because you may see that rates drop, and you might want to refinance. You might even decide to sell the home, in which case, that money you spent on that discount point is completely lost as you can’t recoup it when you sell the house.
If your recoupment is within 24 months by that division calculator or within two years, generally speaking, I’ll say that it’s a pretty decent investment opportunity because you’re making back your discount points within two years. Most people will live in the house for two years and even keep their interest rate for two years, even if refinancing options become aggressive and available.
It’s not a sure bet as there are always risks in every financial transaction you’ll do in your life. However, that’s the general rule of thumb I have. If you can make it back in two years, it’s a no-brainer. Five to six years depends on your plans. I would say anything more than that is probably not a wise investment.
Another thing to think about is what else are you doing with that cash. What would you be doing with it now if you weren’t going to put that $3,360 in the discount point investment? If you’re going to put it in a stock brokerage account like a mutual fund, then you can compare the two. How much do you typically own on that mutual fund per year? How much are you yielding?
When you think about it, $21.74 monthly doesn’t sound like a lot, but if we do the math, $21.74 multiplied by 12 gives us $260.88. Now, if we divide that by the initial investment, you’ll see a return of over 7.7% on your money.
Hence, if you take the $3,360 and put it in some investment instead of putting it towards your mortgage, you have to make sure that you’re earning 8% or more tax-free every year on that investment for it to make sense. So even though you’re not saving that much per month, if you break it down on a percentage level, you’re still making the equivalent of 7.7% on your cash, and that’s in savings, so it’s essentially tax-free.
If you want to find out where the discount points appear on your loan estimate, and you’re not exactly sure how to find them to make these kinds of calculations, I recommend that you go through my article on loan estimates. I covered everything you need to know about your loan estimate, including where you can find every piece of your closing costs, like your discount points or lender credits. This will be useful when you’re trying to make calculations like the ones we did just now.