Reader question: “I have heard it’s a good idea to use discount points to lower my mortgage rate, so I can save money over the long haul. At what point does it make sense to use this strategy? How do I calculate the break-even point for using mortgage discount points? Or will the lender do it for me?”
Your lender should explain how points will reduce your monthly payments, and how long it will take for you to benefit from the strategy. Emphasis on the word should. But it never hurts to run the numbers for yourself, in order to determine how long it will take to reach the break-even point.
Fortunately, the math is simple…
You would simply divide the cost of the points by the monthly savings (resulting from the lower mortgage rate). The number you end up with equals the number of months you will have to keep the loan, before you start to realize savings.
That’s the short answer to your question. Now, let’s take a closer look at how to calculate the break-even point when using mortgage discount points.
A Crash Course in Mortgage Discount Points
Before we go any further, I want to cover a couple of important definitions. The rest of this article will make a lot more sense, once you understand the following concepts.
Mortgage discount point: A fee paid by a borrower to a lender in order to reduce the interest rate on a home loan. One point equals 1% of the loan amount. So if you borrow $200,000, one point would cost you $2,000. Paying points can save you money in the long run by lowering your monthly mortgage payments.
Break-even point: The length of time it takes for the savings from a lower interest rate to equal the cost of paying discount points. For example, if you pay one point to lower your interest rate by 0.25%, your monthly payment will be about $25 less. If the cost of the point is $500, you will break even after 20 months.
These two concepts go hand-in-hand…
To determine if it makes sense to use mortgage discount points, you have to know how long it will take you to break even. If you were to sell the home before that time, you would end up losing money. So there wouldn’t be any benefit.
On the other hand, if you stay in the home and keep the mortgage loan beyond the break-even, your accumulated savings will begin to surpass the extra amount paid upfront. In this scenario, you would clearly benefit by using the strategy.
How to Calculate the ‘Break-Even’ Point
Getting back to the question at hand: How do you calculate the break-even point, when using mortgage discount points to secure a lower rate?
As mentioned earlier, it’s basic division. But you can’t do the math until you have two important numbers. You need to know (1) how much the lender is going to charge for the discount points, and (2) how much you will save each month due to the lower interest rate.
Once you have these two figures, you can determine how many months it will take to reach the break-even point. You’ll then understand whether or not it makes sense to pursue this strategy in the first place.
Remember, paying discount points doesn’t work in every situation. If a borrower only plans to stay in a home for a few years, this strategy could bring more disadvantages than advantages. It might end up costing you money — rather than saving you money. That’s why it’s so important to calculate the break-even point.
Two Things You Need to Know
To recap, you’ll need two important numbers to determine whether or not it makes sense to “buy down” your mortgage rate with discount points:
- How much the lender is going to charge you for the point(s)
- How much you’ll save each month by securing a lower rate
Once you have these two pieces of the puzzle, you can calculate the length of time it will take to “break even” and begin to accumulate savings.
As mentioned, one point equals 1% of the loan amount. For instance, paying one discount point on a $300,000 mortgage loan means you’ll pay an extra $3,000 at closing (300,000 x .01 = 3,000). This part is standard across the industry. It does not vary.
The amount you save each month will depend on how much the lender reduces the interest rate. And this is something that can vary from one lender to the next. There is no industry-wide standard. Generally speaking, however, one discount point will reduce the mortgage rate by 0.25%.
An Example Calculation
Let’s assume you’re purchasing a home for $350,000. Here’s an example of how to calculate the break-even point for paying discount points:
Your lender offers you two options for your home loan:
- Option 1: A 30-year fixed mortgage with an interest rate of 4.5% and no discount points.
- Option 2: A 30-year fixed mortgage with an interest rate of 4% and 2 discount points, which cost $7,000 (2% of the loan amount).
If you choose Option 2, your monthly payment would be lower. But you would have to pay $7,000 upfront for the discount points, in order to get a lower rate and reduce your monthly payments.
To calculate the break-even point, you need to determine how long it will take for the monthly savings from Option 2 to surpass the upfront cost of the discount points.
Here’s what the math would look like:
- Option 1: Monthly payment of $1,773.40
- Option 2: Monthly payment of $1,670.16
- Savings per month: $1,773.40 – $1,670.16 = $103.24
- Break-even point: $7,000 ÷ $103.24 = 67.81 months.
In this example, it would take 67.81 months (or about 5 years and 8 months) for the monthly savings from paying discount points to offset the upfront cost.
If you plan on staying in the home for, say, six years or longer, paying discount points could be a good financial decision. However, if you plan on selling the home before that break-even point, you wouldn’t recoup the upfront cost of the points — and wouldn’t realize any savings.
A good loan officer will be happy to provide you with different scenarios. They can show you how much you will save by paying half a point, a full point, etc. They can also explain how long you would have to keep the loan in order to reach the break-even point, based on each individual scenario.
This is the kind of information you need to make an informed borrowing decision!
Brandon Cornett
Brandon Cornett is a veteran real estate market analyst, reporter, and creator of the Home Buying Institute. He has been covering the U.S. real estate market for more than 15 years. About the author