Monday, February 12, 2007

To Pay, or Not To Pay, Discount Points.

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I recently read a couple of interesting articles regarding loan points and, whether or not, it is wise to pay them; but before we venture into this question, it would be best to explain what loan points are (for those who do not know). Here is how Holden Lewis, an advice columnist for, describes a discount point in his article entitled Paying mortgage discount points - a primer:

"One discount point is an upfront payment of 1 percent of the loan amount, paid at closing. You receive a reduction in the interest rate in exchange for paying discount points. You end up with a lower monthly mortgage payment...Discount points are based on the loan size, not the purchase price. If you borrowed $200,000 to buy a $300,000 house, one point would cost 1 percent of the loan amount, or $2,000. Two points would cost $4,000. Paying discount points doesn't reduce the amount borrowed...As a rule of thumb, the mortgage's interest rate is reduced by a quarter of a percentage point for every discount point you pay. That's just a rough guide, though; the actual amount of the discount varies by lender and can fluctuate in response to movements in the bond markets."

Why Would Someone Want to Pay Discount Points ?

The main reason for paying discount points stems from a general desire to reduce the interest rate on a mortgage, thus, achieving a lower monthly payment upfront. This scenario looks favorable, at first sight. However, in a article entitled "Borrowers Seldom Score By Paying Points," Chief Economist for Quicken Loans, Bob Walters, said otherwise, "If you're going to be in that mortgage longer than the break-even point, you win...if you aren't in that mortgage longer than the break-even point, you lose." Therefore, if you intend to refinance in the short-term, you would not really benefit from paying discount points upfront. Bill Lyons, president of San Diego-based LEI Financial, says that a lot of people would benefit from making an extra payment every year, rather than paying discount points.

According to Holden Lewis you can estimate a breakeven point, to see if it warrants paying discount points, "To find out whether you'll hold the mortgage past the break-even point, you must have a notion of how long you will keep the mortgage. If you plan to sell the house or refinance within two years, it probably doesn't make sense to pay discount points. On the other hand, if you plan to keep the mortgage for 10 years or more, you'll save money in the long run by paying points." Lewis also offered a formula to calculate the break-even point:

"The simplest way to calculate the break-even point is to ask the lender how much you would save per month by paying a certain number of discount points. William Noll, mortgage consultant for Wells Fargo Home Mortgage in Hershey, Pa., likes to do it this way. He brings up a hypothetical example where $1,000 in discount points reduces the monthly payment by $15. He divides $1,000 by $15, for a break-even point of 66.6 months, or roughly five-and-a-half years...Noll doesn't think it's worth the bother if a buyer plans to keep the mortgage for only a little longer than the break-even period. Better to put the money in a certificate of deposit, he says. 'Unless the customer tells me he's maybe going to be in the home maybe 10 years or more, I generally don't recommend points,' he says. 'But I leave it up to them.'"

Source links:

"Paying Mortgage Discount Points: a Primer" By Holden Lewis • "Borrowers Seldom Score By Paying Points"

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