When you see mortgage loans advertised online, you may think those rates are for everybody, but they aren't. Known as benchmark mortgage rates, the best rates are for borrowers with perfect credit and who are buying a home well within conforming loan limits with a large down-payment as icing on the cake.
The rates you see may be teaser rates and they aren't going to be available to you when you apply for a loan. That's because banks will charge you "discount" points to give you their best rate. You're not required to pay points, but it's a choice if you want a lower interest rate.
Explains David Reed, author of Mortgages 101, "points", or discount points, are a percentage of the loan amount. If a mortgage is $200,000, then one "point" is $2,000.
Should you pay $2000 upfront to save a point over the life of the loan? It's a function of how the rate is offered, says Reed.
For each point paid, your interest rate should be reduced by about 1/4 of a point. If you can get a 5.00 percent loan with no points, then you can likely get the same loan at 4.75 percent by paying one point.
The point "discounts" the interest rate, that's why it's referred to as a discount point. You're paying the cost of the discount points in your closing costs in advance. That's cash you could use in your down-payment, or to buy furniture or to upgrade your home.
Reed says he isn't a fan of paying discount points, because the math never seems to work.
On a 30-year mortgage loan at $300,000 and 5.00 percent interest, the monthly payment works out to $1,610 without any points. Paying one point ($3,000) would reduce your rate to 4.75 percent, making your discounted payment $1,564 per month.
That's a reduction of $46.00 per month. Now weigh that against the cost of $3,000. To get that, divide $46 into $3000. The result is 65. What that means is it will take you 65 payments to break even, nearly 5 1/2 years.
What about paying two points? The math is still the same. On that same $300,000 loan at 4.50% and two points the monthly payment is $1,520, or lower by $90.00 per month when compared to the 5.00 percent rate.
Divide that $90.00 into the two points of $6,000 and the result is (drum roll, please) 67. It would take 67 months to break even.
In general, it will take about five years to break even for every discount point paid. If you don't plan on staying in your home for at least five years or more, you won't come out ahead.
"I say take the $3,000 and pay down the principal," says Reed. "Pass on the points."