You now know what costs are involved in originating your loan, and you know that you have options in paying for those costs.
We also have an option to pay a discount fee (formerly known as points) to buy down our interest rate if we wish. Is it possible that paying points can save you money? Let’s see how that works and why we might want to do it.
Going back to our previous example in our videos on closing costs, let’s say we have this much in origination costs and we are going to pay this much every month for the rest of our lives.
It turns out that we can pay some additional money up front, and buy down the interest rate if we want to have lower payments. Money paid now buys lower payments for the life of the loan. This impacts the lifetime cost of your loan in two ways:
First, obviously, we’ll have lower mortgage payments, because our interest rate will be lower.
But our monthly payments last a lifetime, so we’ll have more money in our pocket after a few years. This is the opposite of financing your closing costs. By paying more up front, we will pay less over the life of our loan.
To understand this next point, remember that our mortgage payment is not all cost. Some of it goes to pay interest for renting the money – that’s a cost. Some of it – not much at first, but more in later years – goes to paying down the principal balance of the mortgage. The principal portion isn’t a cost, it’s actually an investment. We are investing money from our savings into the equity in our home. The longer we pay our mortgage, the less of our payment goes to interest, and the more to principal.
But – here’s the thing. When we pay money up front to buy down the interest rate, the savings in our monthly payment doesn’t come out of the principal portion of our payment – it comes out of the interest portion.
And, because less interest will be charged every month on the remaining balance, more of our payment goes towards principal every month in the early years.
Keeping that in mind, the second impact paying points has on our lifetime costs is that the lower our interest rate, the faster we are buying equity in our property.
Eventually we will pay the loan off either way and owe zero. But the lower the interest rate – all other things being equal – the more equity we will have in our home after our first payment until the very last.
So if this is why we want to pay points to buy down your interest rate, how do we do it?
As a general rule, buying our interest rate down 1/8% will cost us between one-quarter and 1point, with 3/8 to one-half being most common. The math is a bit messy, but rules of thumb are too general to be useful.
To best calculate which option will cost us less in the long run, we first have to estimate how long we will keep the loan. This may or may not be the same length of time we keep the house. Of course we might end up being wrong, but it’s almost always a better guess than 30 years.
Then we have to calculate the interest we will pay of that time period. It’s not as easy as you might think, but it isn’t impossible either. We need to know:
- Our total payments over the holding period (payment times the number of months ought to do it.)
- The original balance of the loan (not hard.)
- The balance at the end of the holding period (any good amortization calculator will tell us this.)
Then, we do the following:
- Subtract the balance at the end of the holding period from the original balance. That’s the principal we’ll pay.
- Subtract the principal we’ve paid from the total payments we’ve made. That’s the interest we’ll pay.
- Add the interest we will pay to the up-front costs, and that is the projected cost of that loan option over our estimated holding period.
As a general rule of thumb – remember I don’t like these – if we keep the loan for less than three or four years, chances are it’s smart to not pay points for a lower interest rate. If we keep the loan for more than four or five years, it probably does make sense.
But we can figure this out exactly – it is math after all – if we know the loan amount and the interest rate and discount fee (points) of both options. If your mortgage advisor can’t do this for you, find another mortgage advisor.
And most importantly, don’t automatically reject loans with discount fees. In some cases, paying points can save you money. You may end up with tens of thousands of dollars more in your pocket with one.