Think the loan with the lower interest rate is always a better deal? Not necessarily. The interest rate is a critical component of a mortgage package, but so are discount points.
A discount point is a dollar amount equal to 1% of your mortgage loan. It can be thought of as prepaid interest on your loan. It may be helpful to consider both the interest rate and the associated discount points when calculating the cost of your loan. A mortgage loan at 5% and three discount points is quite a bit different than a mortgage loan at 5% and no discount points.
Why pay discount points?
Discount points are used to buy down the interest rate you're charged on the loan. In other words, there's a trade-off between your interest rate and the discount points you pay. For any given loan, you can usually lower the interest rate by agreeing to pay more discount points, or you can lower your discount points by accepting a higher interest rate.
In general, each discount point paid will reduce your mortgage interest rate by approximately 0.25%. Therefore, paying discount points will lead to reduced monthly payments and interest over the life of your loan. Because discount points are paid upfront, you will need to provide more cash at closing for your new home.
On the other hand, if you decide you don't want to pay any discount points, you won't need as much cash at closing.
Should you pay discount points?
If you’re deciding whether or not to pay discount points, ask yourself these questions:
- How long do you plan to stay in your new home?
- How much can you pay each month?
- How much do you have available to pay upfront?
Typically, if you plan to stay in your home five years or more, it might make sense to pay some discount points to get a lower interest rate. However, if you are planning to sell in a few years, it may make sense to trade a higher interest rate in return for paying fewer discount points.
Another important consideration is your available funds for closing. If you have limited available funds for closing and are able to pay a slightly higher monthly amount, you might be better off paying no points.
Don't forget that discount points are generally tax deductible in the year paid when real estate is acquired. Discount points paid when refinancing are also generally tax deductible, but the deduction is spread out through the life of the loan. Consult your tax advisor for information regarding deductibility of interest or discount points.