Pros and Cons of Paying Mortgage Discount Points in California

According to Freddie Mac, the average rate for a 30-year fixed mortgage loan recently rose to its highest level since 2001. During the week of August 24, 2023, they reported that 30-year mortgage rates were averaging 7.23%.

Because of this trend, we could see an increase in the number of California home buyers who use mortgage discount points to secure a lower rate. But what is a “mortgage point” exactly, and when does it make sense to use them?

In this article, we will explore the pros and cons of paying mortgage discount points when buying a home in California. This will help you make a more informed decision, based on your unique financial situation and long-term goals.

Pros and Cons of Mortgage Discount Points

A mortgage discount point is a one-time fee that a borrower pays to a lender in exchange for a lower interest rate on their mortgage loan. Each point equals 1% of your loan amount. So, if you take out a mortgage loan in the amount of $600,000, one point would cost you $6,000.

A single mortgage point typically reduces the borrower’s interest rate by 0.25%.

Like all financial decisions, there are certain pros and cons when it comes to using mortgage discount points on a California home purchase. The overall goal, from a borrower’s perspective, is to maximize the upside and minimize the downside. So let’s explore both sides of it.

Pros: A Lower Interest Rate

When you buy discount points, you are essentially prepaying some of the interest that you would otherwise have to pay over the life of the loan. This lowers your interest rate, which in turn lowers your monthly mortgage payments (more on that below).

The amount of interest rate reduction that you can get by buying discount points depends on a number of factors. These variables can include current market interest rates, the type of mortgage loan you are using, and the lender you choose.

Generally speaking, however, you can expect to lower your interest rate by about 0.25% for each point that you buy. Two points would reduce the rate by 50%, and so on.

If you’re planning to stay in the home (and keep the same mortgage loan) for many years, you could save a significant amount of money in total interest charges. After all, you pay interest on each of your monthly payments. So when you secure a lower rate, the savings tends to accumulate over time. The longer you keep the loan, the more you can benefit.

We will talk more about how to calculate your savings and benefits in a moment. But for now, let’s keep exploring the pros and cons of paying mortgage discount points.

Pro: Smaller Monthly Payments

Your interest rate is one of the four primary components that make up your monthly payments. In a typical home loan scenario in California, the mortgage payments are comprised of:

• The principal amount borrowed
• The interest rate assigned to the loan
• Property taxes assessed on the property
• Insurance related costs

This means that if you secure a lower interest rate by using mortgage discount points, you can also reduce the size of your monthly payments. And those savings will add up over time.

Of course, you’ll be paying some extra money up front, to make those long-term savings possible. So you have to consider those pros and cons as well. When it comes to mortgage discount points, you’re basically spending money in advance to save money in the long run.

Con: Added Upfront Costs

The cost of points is typically expressed as a percentage of the loan amount, such as 1 point or 2 points. For example, if you have a $600,000 mortgage and you buy one point, you will pay $6,000 more at closing.

This additional upfront cost might be cost-prohibitive for some California home buyers, especially those who are already struggling to come up with a down payment.

Con: Might Not Pay Off if You Sell or Refinance

If you sell or refinance your home within a few years of buying it, you may not have enough time to recoup the cost of the points. This is because the savings from the lower interest rate will be offset by the upfront cost of the points.

Again, the goal here is to save more money over the long term than the extra amount you pay up front to purchase points.

This strategy tends to work best for homeowners who are planning to stay put for a long period of time, or at least beyond five or six years. If you sell or refinance the home too soon, you could defeat the whole purpose of using discount points.

Con: Reduces Your Available Cash

Paying extra for points also reduces the amount of cash you have available for other expenses, such as a down payment, closing costs, furnishings, or home improvements.

Calculating the Breakeven Point

The pros and cons of paying mortgage discount points all come down to one thing: the break-even point. This is the most important concept to take away from this article, because it determines whether or not it makes sense to buy down your interest rate.

In this context, the break-even point is the amount of time it takes to recoup the upfront cost of paying points. In other words, it is the number of years it takes for the savings on your monthly mortgage payments to equal the cost of the points.

Here’s an example that shows how to calculate the break-even point:

• Loan amount: $600,000
• Initial interest rate: 7.2%
• Interest rate after paying two points: 6.8%
• Monthly payment without points: $3,404
• Monthly payment with points: $3,304
• Amount of money saved each month: $100
• Upfront cost of points: $12,000
• Break-even point: 10.8 years

As you can see, paying two points lowers the monthly payment by $100. However, it also costs $12,000 upfront. The break-even point is 10.8 years, which means that if the homeowners stay in the home for at least 10.8 years, they’ll save money by paying points. But if they plan to move sooner than that, they might not recoup the cost of the points.

If you’re thinking about paying mortgage points when buying a home in California, ask your lender to provide you with a breakdown that calculates the break-even point. Better yet, contact our staff to get a specific mortgage loan quote and cost estimate!