Most people think paying points is bad. While it does add to your closing costs, there are times it is warranted. Understanding how the fees work and why you would pay them can help you make the right decision.
Some borrowers do not have a choice – without an origination fee, they would not get a loan. It’s the lender’s way of making sure they make money.
Sometimes, though, lenders charge discount points. This fee helps lower your interest rate. Not every borrower should pay it. Let’s look at when and how you should make this decision.
Paying Discount Points May Help you Save Money
It sounds counterintuitive. You pay higher fees to save money. But it works. The more you pay the lender now, the less you will pay in interest over the life of the loan.
Think of it as a one-time fee versus a 30-year fee. Of course, you will still pay interest. It just will not be as much.
If you plan on living in your home for a long time, it may make sense to get the lower interest rate. If you are unsure, look at the total interest costs over the life of the loan for both rates. You will likely see a several thousand-dollar difference.
You May Save on Refinancing Fees
Refinancing costs money. The closing costs you are about to pay on your mortgage you will pay again.
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Does paying another 3-5% of your loan amount sound good? If not, consider buying the rate down now. Discount points can help you secure an interest rate you will keep.
Without the need to refinance, you save more money down the road. An exception, of course, is if you need to tap into the equity of your home.
You Can Lower Your Debt Ratio
Borrowers who have a borderline debt ratio often benefit from paying points. Imagine your debt ratio is 44%. You are applying for an FHA loan. The maximum allowed is 43%. That measly 1% could leave you without a mortgage approval.
If you have extra cash lying around, though, you may be able to pay points and bring your rate down. This brings your mortgage payment down. Like a domino effect, your debt ratio decreases too. Suddenly, you may have a mortgage approval.
Discount Points Provide a Tax Deduction
Do not forget when you file your taxes, you may be able to deduct the points you paid. You are only eligible to do this during the year you pay the points, though.
In other words, you can’t carry the deduction over into future years. Talk to your tax advisor before paying the points to see if you would be eligible. Every deduction can help you lower your tax liability.
When It’s not Smart to Pay Discount Points
This doesn’t mean it’s always the right idea to pay points on a mortgage. The following situations usually don’t warrant the extra fee:
- You know you will live in the house for a short period. Paying the higher interest rate for a short amount of time usually costs less. Of course, you should do the math to make sure you come out ahead.
- You don’t have the extra money after making your down payment. Stretching yourself thin before you move into your home isn’t a good idea. If you have just enough for the down payment and basic closing costs, take the higher rate. You’ll need extra money for moving costs and getting established in your new home.
- The cost savings isn’t worth it. Every lender charges their own points and decides the appropriate rate reduction. If you do not feel like prepaying the interest upfront with discount points is worth it, don’t do it. You can always make extra payments down the road. This may knock a few years off your payments and thousands of dollars off your interest paid.
The bottom line is paying points is a personal decision. No two borrowers will have the same decision. Take into consideration the money you have saved, your debt ratio, and your plans for the home.
Ask lenders to provide you with quotes for both loans with a discount point or two and without.
Once you have both quotes, you can look at the big picture. Compare the amortization tables and the total amount of interest paid. Also, look at the APR. This will give you a better idea of the full cost of the loan over its entirety. Only then can you make the right decision for yourself.