Mortgage Discount Points

If you’ve been shopping around for a mortgage you have undoubtedly heard the term “points” mentioned many times. But if you are like most people, you haven’t the slightest idea what it means.

What are Mortgage Discount Points?

When people talk about mortgage points, they are usually referring to mortgage discount points. Each point is equal to one percent of the amount borrowed. For example, on a $250,000 loan one point is $2,500.

When you purchase points, you are basically prepaying part of your mortgage interest. For every point you pay, the lender will lower your interest rate. The amount of the decrease can vary, but it is typically about a quarter of a percentage point per discount point purchased.

For example, if you borrowed $200,000 and bought two points, it would cost you $4,000 and your rate would drop by half a point. Most lenders will allow you to purchase up to three or four points.

But before you rush off to buy all the discount points you can, there are a couple things you need to consider.

First of all, can you afford to purchase discount points? Or would the money do you more good elsewhere. Most people are pretty strapped for cash when they are buying a new home. You’ll have to pay the down payment, plus closing costs, and moving expenses. And you’ll probably want to do some work on the house to make it your own. Those discount points could pay for some painting, landscaping, or other projects.

Even if you have the extra cash and don’t want to put it toward the down payment or home improvement projects, you can likely get a better return elsewhere. Think about it.. if you bought three points on a $400,000 loan it would cost you $12,000. If you invested that money in stocks or bonds, you could likely earn more than you would save in buying the discount points.

The other major consideration when deciding whether or not to buy points is how long you expect to live in the home. The longer you expect to stay, the better deal points offer.

Buying discount points is simply prepaying part of your mortgage interest up front. Since you paid up front, the lender comes out ahead for the first few years. But eventually your monthly savings will exceed the amount you paid up front, and you end up the winner.

So the key is to calculate the break even point. If you leave before the break even point, the bank wins. If you leave after, you win.

How long it takes to reach the break even depends on your interest rate and the amount you paid in points, but for most loans it falls between five and six years. You should use an online calculator or ask your lender to break down the numbers for you so you can determine the break even point for yourself.

Guest post courtesy of Your Money Review. Visit YourMoneyReview.com for all your credit needs. Compare Mortgage rates, Refinance rates, get an Insurance quote, order a free copy of your credit reports and much more.