Many first-time home buyers don’t understand the concept of discount points and whether or not this option is a good idea for them.
What is a Point?
One discount point is an upfront payment of 1 percent of the loan amount paid at closing. These points are paid directly to the lender in exchange for a reduced interest rate. Paying mortgage points to “buy down the rate” which can lower your monthly payment may seem like a good idea, however it doesn’t necessarily make sense for every homeowner.
While there is no direct correlation between rates and points - in general, for each ½ point, you can drop your rate 1/8 percent.
As mentioned above, each point costs 1% of the mortgage amount. The more points you pay, the lower your mortgage rate. So which is the best for you? More points and a lower rate? Or fewer points and higher rate?
To answer that question, you have to guess whether you’ll keep the mortgage past the break-even point - the time when your accumulated monthly savings exceed the amount you paid in points.
If you plan to sell the house or refinance within a couple of years, it probably doesn’t make sense to pay the points.
To better understand how this works suppose Patrick and Jane Doe took out a 30-year fixed mortgage of $165,000 at 6 percent interest with no points. The monthly mortgage principal and interest payment would be $989. If you pay 2 points at closing (that's $3,300) you can bring the interest rate down to 5.5 percent, with a monthly payment of $937. The savings difference would be $52 per month. But it would take 64 months to earn back the $3,300 spent upfront via lower payments. If you're sure you will own the house for more than five-and-a-half years, you save money by paying the points.