Most people, especially home buyers, are aware that mortgage interest rates have been steadily rising from less than 3% in 2021 to recent highs of around 7%, but what they may not realize is that at the same time there has been a surge in borrowers paying to get a lower interest rate.
About 45% of borrowers purchased mortgage points (also known as discount points) to reduce their monthly payments in 2022. This compares to 29% of borrowers who purchased mortgage points in 2021, 28% in 2020 and 27% in 2019, according to a recent analysis by Zillow Home Loans.
“As soon as mortgage rates began to rise in 2022, we began to see an increase in buyers purchasing discount points,” says Nicole Bashaw, senior economist at Zillow in Seattle. “We don't have data for 2023 yet, but because interest rates are relatively high compared to past years, it's possible that the percentage of borrowers purchasing points will remain the same or even higher this year.”
How home loan points work
Borrowers can purchase mortgage points, which are 1% of the loan balance, to lower their mortgage interest rate. The amount of discount varies depending on the loan and lender, but one point typically lowers your interest rate by 0.25%.
For example, discount points on a $400,000 loan would cost $4,000 and lower your interest rate from 6.5% to 6.25%, saving you about $65 per month.
Discount points are essentially upfront interest rates on a loan, but some borrowers confuse them with origination points, says Chuck Cavanaugh, head of financial planning and pension distribution at Citi in New York City.
“Origination points are a fee that lenders charge for processing a loan, while discount points are optional for borrowers,” Cavanaugh says.
Why discount points are popular when interest rates are rising
Discount points lower your mortgage interest rate over the life of the loan, so people pay points to make their payments more affordable. Rising home prices combined with rising mortgage rates make paying discount points attractive right now.
“When interest rates are low, borrowers aren't really interested in lowering their interest rate by 0.25% because they're already low,” Basho says. But when interest rates are high, borrowers look for any way they can reduce their monthly payments.
Psychological factors may also be at play, says Mike Salierno, a financial adviser at Northwestern Mutual, a financial-services company in Clearwater, Fla. “Some people just want to say they're getting a mortgage rate below a certain amount or that they're getting a better deal than their neighbors.”
An important step in determining whether buying discount points makes sense for you is to calculate your break-even point, which is the point at which your monthly savings exceed the amount of cash you paid for the points.
For instance, in the $400,000 loan example above, the breakeven point would be about five years and two months ($4,000 divided by $65 is roughly 62 months), so in this case it would only be worth paying the points if you plan to live in the home for at least five or six years.
“It really comes down to how long you plan to live in the home and whether you're likely to refinance before you break even,” Salierno says.
Who buys mortgage points?
Every buyer wants the lowest interest rate possible, but not everyone has the cash to lower their interest rate, and Zillow's research shows that buyers who buy the most discount points buy homes in the mid- and high-end ranges of their market.
Cavanaugh noted the same pattern: “Even small cuts in mortgage rates can have a big impact on larger loans.”
Conversely, when broken down by income level, Zillow's analysis found that paying points is most common among borrowers who earn 30% to 50% of the area median income, likely because these borrowers are most concerned with their ability to make monthly payments.
In some cases, these borrowers qualify for down payment assistance or first-time buyer programs with lower closing costs, so they can use the savings to lower their mortgage interest rate instead of putting it toward other upfront costs. “This is another avenue to homeownership for some buyers,” Basho says.
Cash-out refinance borrowers were more likely to buy mortgage points than other borrowers. “When homeowners refinance out of a cash-out, they have a sense of being flush with cash, so they're willing to pay a discount of one or two points to get a lower mortgage rate,” says Bashaw. “And when you refinance, it's clear that you plan to stay in your home for a long time.”
Should I make a bigger down payment or get more discount points?
If you're saving up cash to buy a home, you might consider making a larger down payment rather than lowering your mortgage interest rate.
Having the cash to make a 20% down payment can have a bigger impact on your payment than lowering your interest rate, Cavanaugh says, because a 20% down payment lets you avoid paying private mortgage insurance.
Once you pass the 20 percent threshold, buying discount points often offers a better margin of return than making an additional down payment, but Cavanaugh says it's important to crunch the numbers.
For example, if your loan balance is $400,000 and you pay an additional $4,000 as a down payment, your monthly payment at a 6.5% interest rate would be $28 less, compared to a savings of $65 if you chose to purchase discount points for that amount.
“Your mortgage interest rate may be lower if you make a larger down payment, so you'll need to analyze all scenarios with your lender,” Basho says.
Establishing a solid emergency fund and paying down high-interest credit card debt should be prioritized over trying to get a small hit on your mortgage rate, Cavanaugh advises.
If you have extra cash left over when purchasing or refinancing, talk to a lender or financial advisor to determine the best way to use it.
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