Most home owners will refinance their homes at some point in their lives. The good news is that not only is a refinance usually a less stressful experience than the purchase of a home, but it often becomes an opportunity to reduce one’s monthly payment and save money in the long run through a reduction in rate. What some do not know, however, is that additional savings can often be gained by purchasing a deeper reduction to the rate through what is called discount points. Determining whether the purchase of discount points is right in any given refinance requires good communication with one’s mortgage specialist and a little bit of number crunching.
Discount points should not be confused with origination points or a buy down. Discount points are an optional fee that the borrower chooses to pay to the lender at the time of closing to permanently reduce the rate on the loan. How much the discount points will cost is determined by the lender on a graduated scale at the time the mortgage specialist locks the loan. What the exact costs will be and how much of a discount should be purchased, if at all, should be thoroughly discussed with one’s mortgage specialist and chosen by the borrower, just as the rate is discussed and agreed upon for the rate lock.
The following outlines a scenario on how to figure discount point costs and if they would be prudent for the borrower to buy:
Julie is refinancing her home at a loan amount of $150,000 at 5.75% for 30 years, making her refinanced principle and interest payment $875.36/month. After discussing the possibility of buying discount points with her mortgage specialist, she learns that the chosen lender will extend discount points at a cost of .5 points (.5% of the loan amount) for a .25 reduction to the rate, 1 point (1% of the loan amount) for a reduction of 1 to the rate, or 2 points (2% of the loan amount) for a 1.25 reduction to the rate. To figure the cost of the discount points use the following formula: Discount Points x Loan Amount = Cost
To figure the new payment, the new numbers must be plugged into a mortgage calculator. The first example has already been figured below:
.5 discount points x $150,000 = $750;
This gives Julie a .25 reduction to the beginning rate of 5.75%. 5.5% is now the permanently discounted rate at a cost of $750. Her new principle and interest payment will be $851.68/ month at this rate, making a difference of $23.68/month saved.
The question that Julie needs to ask herself here is, “Is it cost-effective to purchase these discount points on my home?” Using Julie’s example above, she will have to pay $750 at closing in order to save $23.68/month. That means when she takes the $750 it will cost and divides it by the monthly savings of $23.68, it will take Julie 31.67 months to recoup her cost to discount. If Julie is going to own this house for longer than 31.67 months, then the answer is, “Yes, it is worth it to buy the discount points.” If Julie is not planning on owning her house for that long, then the answer is, “No.” Now Julie can run the calculations on the next two tiers of discount to see if either of those discount points costs would give her more in savings for how long she intends to own her home before making her decision.
There are a few more things to consider when deciding if buying discount points is the right decision. It is important to know that some of the fees charged at closing, including discount points, may be able to be written off on taxes in the year the refinance was acquired (consult a tax professional to ensure validity of this claim in each and every home refinance or purchase), which can give a little extra punch to the savings effected by buying the discounted points. It is also important to consider how this extra cost is being paid. Most people are fortunate enough to have available equity in their home at the time of refinance to roll all of the closing costs, including the discount points, into the new loan amount. However, if there is not enough equity and part of the closing costs must be paid out of pocket, determining if the money saved each month is worth what is taken from real cash is an important detail to consider.
Discount points can be a valuable tool for a borrower when used correctly. Remember that each situation is different and what may be right for one borrower may not be for another so doing the math, consulting with advisors, and being realistic on ownership longevity are all key considerations to saving.