Selling Point: How do Origination and Discount Points Affect a Loan?
I want to make a point about points - origination points and discount points. These loan terms can be confusing to new - and even not-so-new - homebuyers who are navigating today's scorching-hot housing market. So, let's get to the point...Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Here's My Point
With all the hoopla accompanying today’s frantic search for affordable housing (if there is such a thing), questions about “discount points,” and “origination points” keep coming up in conversations about home loans. So, what is a "point" in this context? Put simply, a point is 1% of a home loan. So, if you were looking to borrow $400,000 to buy a house, a point is equal to $4,000.
Let's get into more detail.
Let’s first talk “origination points,” which is a type of mortgage point fee that doesn’t lower your interest rate. It’s a fee paid to your lender or loan officer to compensate for evaluating, processing, and approving your mortgage loan. They represent a way to pay closing costs and are negotiable among lenders, but most charge between 0.5% and 1% of the total loan amount. Origination points are not tax deductible.
You usually come out ahead if you can negotiate an out-of-pocket fee versus paying origination points. In fact, not all lenders charge for work done on your mortgage, so clear the air on that possibility before even considering paying origination points…or a flat fee.
“Discount points” are points you can buy up front to lower your mortgage loan’s fixed rate interest. It’s commonly called “buying down the rate.” One discount point typically equals 1% of your total loan amount, which if paid, lowers your mortgage interest rate by about 1/8th to 1/4th of a percent. But heads up: The actual percentage change will depend on your mortgage lender so it’s important to shop for your best mortgage rate. Different banks offer different rate reductions in exchange for paying points.
So, why would you want to buy a discount point? It could reduce the amount of interest you’ll pay over the life of your loan AND it could reduce your monthly mortgage payment - both good things. In addition, they are generally 100% tax deductible in the year paid but only if a lengthy series of IRS tests are met.
NOTE: Discount points are not advisable unless you plan to stay in the home long enough to offset the front-end cost. What does that mean? Selling your home or refinancing your mortgage before achieving break-even can render discount points a waste of money. U.S. Census data suggests that the average American moves a dozen times during a lifetime, so if there's a chance you might relocate in a few years run the numbers before buying these points. In short, points pay off only if you keep the loan long enough to realize savings from the reduced interest rate. A less risky alternative is making a larger down payment to increase your home equity.
If you are entertaining an adjustable-rate mortgage, discount points paid up front might not be a good idea. They usually affect only the initial rate, saving you less in the long run.
A Pointed Example
Let me make my point with an example.
You make an offer on a $300,000 home and it's accepted. You make a 20% down payment and take out a 30-year fixed-rate conventional loan of $240,000 at a 4.5% interest rate. To lower the rate, you’re willing to pay the lender one discount point (1% of the $240,000 loan amount) or $2,400 at closing.
For this 1% dicount point, your lender reduces the interest rate by 1/4 percent (from 4.5% to 4.25%). This reduces your monthly payment by $36 per month (from $1,562 to $1,526). Over the 30-year loan life, you would save $12,743 of interest (from $197,778 to $185,035) by paying this one discount point that costs $2,400. When you deduct the front-end cost of $2,400 from that, you have a net savings of $10,343.
What is APR?
When comparing current interest rates of competing mortgage lenders, you’ll often see three numbers listed: mortgage interest rate, points, and the Annual Percentage Rate (APR).
APR is a calculation that shows the long-term cost of holding a mortgage, including mortgage insurance (required for most types of mortgages). It also reflects the effect of discount points on your rate, and it assumes that the borrower will keep and pay off the loan for its full term and on schedule – which seldom is the case. So, remember, your ultimate APR is not your mortgage rate. Using the “lowest APR” method is rarely wise when you are searching for your best loan prospects.
You’re really just prepaying interest by buying discount points. The more points you buy up front, the more interest you prepay – and lenders are very willing to lower the interest rate on your loan in exchange for those early payments. But if you think you’ll be moving out of the new home before achieving break-even, then seriously consider using those front-end dollars to increase your initial down payment (equity) instead of buying down your mortgage interest rate.
Generally speaking, it’s the less risky move. Good luck on finding that dream home!