When getting a home loan, you have to make a lot of decisions. That includes whether to go for a 30-year or 15-year loan, which lender to choose, and how much to spend up front. If you have the option to pay points, you may wonder if that cost makes sense, and how to budget your dollars between your down payment and any points.
Both expenses come out of your pocket up front (unless you finance the points), so the immediate impact on your budget is identical. Likewise, both points and a down payment can reduce your required monthly mortgage payment. However, over the long term, they impact your finances in different ways.
As a quick refresher, let’s discuss the difference between points and a down payment. Then, we’ll evaluate when one option might be better than another.
- Both points and a down payment can reduce your required monthly mortgage payment, but they impact your finances in different ways.
- Discount points lower the rate on your loan in exchange for a payment up front (or over time if you decide to roll points into your loan).
- A down payment is an amount you pay up front toward the purchase price of a property, reducing your loan balance and increasing your equity.
- Use a points calculator to determine how much you’ll save by paying points, then compare those savings to a smaller loan using an amortization table.
Discount points lower the rate on your loan. In exchange for a payment today, your lender reduces the interest rate on your debt. This is sometimes called “buying down the rate” on your loan, because you’re effectively purchasing a lower rate.
To view it another way, you might say that you’re paying interest in advance, and your lender is adjusting your interest rate accordingly.
You can’t recover interest costs—that money won’t come back to you when you sell. As a result, you need to benefit from interest expenses in other ways (and make sure the numbers still add up for your budget). There are several potential ways you can benefit from paying points, including:
- Potential tax benefits from the money you spend on points
- A lower monthly payment, resulting in a more comfortable cash flow situation in future years
- A lower rate on debt over the years (if you keep the loan long-term)
A down payment is an amount you pay up front toward the purchase price of a property. This amount reduces your loan balance and represents your ownership interest in the home (increasing your equity).
When you borrow money to buy a home, you are still the owner of the home. But your lender may have a lien on the property, which restricts your ability to transfer the property or borrow against it, until you pay off all of your debt.
Making a down payment is similar to using your home as a piggy bank. The home acts as a store of value: Assuming the home does not lose value, you can recoup that value when you sell the property. Alternatively, you can borrow against that value with second mortgages or use that value as collateral for other needs.
Your Payments With Points and Down Payments
Both discount points and a larger down payment should result in a lower required monthly mortgage payment. Monthly payments are calculated using a few factors:
- The interest rate
- The loan amount (also known as the balance)
- The loan’s term (or length of time that the loan is scheduled to last)
By reducing any of these items, the monthly payment also goes down. In addition, the amount of interest you pay also decreases. Interestingly, you can keep the loan amount level but reduce total interest costs by lowering the rate or shortening the life of the loan.
Different inputs lower your payment, but they do it in different ways. The best way to observe the differences is to experiment with a loan calculator or use amortization tables to evaluate various loan alternatives. Most importantly, look at the interest costs over time, and over the life of the loan.
What Should You Do?
With a better understanding of how the payment and interest costs change with each option, you should have an easier time evaluating your lender’s options (and deciding what to do with your cash).
If you have the cash available, and you plan to stay in your home for a long time, points are worth considering.
Here are some questions to ask as you explore your options:
- Estimate how long you’ll really keep your loan. With a longer period, you may be better off paying points and paying interest at a lower rate.
- Check the breakeven period on your points: Figure out how much you’ll save each month on your payment, and calculate how long it will take to recoup the amount you spend up front. Then, remember that your total interest costs may also be different if you pay points.
- Explore the potential tax impacts with your tax advisor. Paying points might give you a deduction today, and that may be more beneficial than interest savings in future years. Don’t forget that interest costs may also be deductible—but spending money for a tax deduction is still spending money.
- Evaluate alternative uses for the funds, and decide whether you should do something with the money besides putting it toward your home.
- Decide whether you think you’ll be able to refinance at a better interest rate in the somewhat near future. If your credit scores or income improve, you might qualify for a better loan. Likewise, look at current interest rates and whether or not you expect them to rise, fall, or stay level.
- Run the numbers on financing points. Rolling points into your loan balance may not be as advantageous as paying out-of-pocket, but it may be worth a look.
Use a points calculator to determine how much you’ll benefit from paying points. Then, compare those savings to a smaller loan (using an amortization table). For example, on a $300,000 loan, evaluate the savings that come from a lower interest rate if you pay two points (or $6,000). Then, see how the loan looks if you only borrow $294,000—adding that $6,000 to the down payment instead of putting it toward points.