By: AnnaMarie Mock, CFP®
Whether you are a first time home buyer or a seasoned mover, there are many intricate details involved with taking out a mortgage. If you are purchasing or refinancing a home, there may be an opportunity to lower the interest through buying mortgage points. Although a lower interest rate sounds appealing, there may be drawbacks depending on your unique situation.
Mortgage points, discount points, and closing points are one in the same. Mortgage points are paid to a mortgage lender or broker in exchange for a reduced interest rate on a mortgage loan, which is commonly referred to as “buying down the rate”. The cost of one mortgage point is 1% of the total amount of the loan, and the borrower is essentially prepaying the interest with an upfront fee. There is not a standard rate reduction when a mortgage point is paid; the reduction varies based on the loan type, lender, and prevailing rate. The interest rate decrease commonly ranges from an eighth to a half of a percentage point.
There are some key questions and factors to consider when evaluating the best course of action for the mortgage.
1) Do you have additional cash available in excess of the down payment, closing costs, and emergency fund reserves to buy down the rate?
It may not be prudent to exhaust your cash reserves to pay down the mortgage points if you do not have additional liquid resources. It is imperative to have an established emergency fund set aside for unforeseen expenses because it ensures that debt sources (like credit cards) do not have to be utilized in the event of a financial emergency.
2) How long do you intend to own the home? Will you sell it before the breakeven period?
If you sell your home before the breakeven point, you may lose the financial advantage of buying down the points. For this additional, upfront expenditure to be worthwhile, the interest savings must exceed the cost of points paid. The length of time to recoup the cost of buying the points varies based on the terms of the mortgage. To calculate the breakeven point, or the point where monthly payment savings surpass the cost of the points, divide the cost of the points by how much you save on the monthly payment.
Example: You purchase a home with a market value of $375,000 and make a 20% down payment of $75,000.
Loan Value $300,000
Mortgage: 30 year fixed rate
Mortgage Points: 1 Point is equivalent to 0.25%
Closing Cost Fees: 5% ($18,750)
By buying one mortgage point, you would have to remain in the home for about 5.5 years (66.7 months) to reach the breakeven point. If you will not realistically live in the home for that span of time, then buying down the points may not be the correct path.
All in all, a lower interest rate means there are lower monthly mortgage payments and less interest paid during the life of the loan. In addition, mortgage points are usually tax deductible on your Schedule A under the mortgage interest section. However, by paying down the mortgage points, this will increase the cash needed upfront to close and extend the timeframe to breakeven on the purchase. Before committing, compare all options and determine which will have the best financial impact based on your situation.
If you have any questions related to mortgage loans or points, please do not hesitate to reach out to the HIGHLAND team.