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Should I pay points when refinancing?

Published | Editorial Disclosure

Last week, mortgage rates once again flirted with all-time lows, as 30-year fixed rates dropped to 2.8%.

Many lenders discontinued rolling a refinance fee of 0.5% into their borrowing costs. With the fee now becoming old news, refinances are an even better deal than they were before.

The drop in interest rates and the removal of the refinance fee sparked another flurry of refinance applications. In fact, refinance loans accounted for more than 67% of all mortgage activity last week.

With rates already at or near record lows, does it really make sense to pay points to buy down the rate even further? The answer is a resounding “it depends”.

The way discount points work

Mortgage points, commonly referred to as discount points, are fees paid to your lender to lower your interest rate. This is sometimes known as “buying down the rate.”

Buying down the rate means paying loan discount points to get a lower interest rate. The end result is that you could pay less over the life of your loan.  

Typically, each discount point costs 1 percent of the mortgage loan amount. So, one point on a $250,000 home loan would cost $2,500.

How much each point lowers the rate varies from lender to lender. The rate-reducing impact of mortgage discount points also depends on the type of mortgage loan, as well as the overall interest rate environment.

Each point typically lowers the rate by approximately .25 percent. If today’s “par rate” were 3.25%, for example, one point would lower your interest rate to 3%.

Homeowners can buy more than one point. They can also buy fractions of a point.

How paying points could save you money

If you have the means to comfortably pay for discount points, doing so could save you a lot of money.

Here’s how paying one discount point could impact a 30-year, fixed rate mortgage on a loan amount of $300,000.

Loan Amount$300,000$300,000
Mortgage Rate3.25%3%
Discount Points$0$3,000
P&I Payment$1,302$1,262
Total Interest$170,023$155,333
Savings $14,690

Monthly savings, as well as long-term interest savings, aren’t the only way you may be able to save money when it comes to paying points.

Purchasing points is essentially prepaying interest. That means points may be tax-deductible. If you meet the IRS’ requirements, you may be able to take the full deduction in the first year. If not, the deduction will be spread out over the lifetime of the loan.

When NOT to buy down your rate when refinancing

Buying discount points can make great financial sense. If you have a long-term investment property or a home you plan to hold onto for many years, paying points could result in a ton of savings.

However, there are times where you wouldn’t benefit from spending money on loan discount points. Every mortgage loan will have a breakeven point that should be factored in when considering points.

In the $300,000 refinance example above, the mortgage borrower would save $40 per month. In order to calculate the breakeven point, you would divide the cost of the points by the amount of the savings each month.

$3000 / $40 = 75 months

The breakeven for this example means this homeowner would need to stay in the home for six and a quarter years to recover the cost of the discount points. Otherwise, paying points just wouldn’t offer the same benefit.

On the other hand, the longer you stay in the home beyond the breakeven point, the more you’ll save as the interest rate reduction continues generating monthly savings.

How to buy mortgage discount points

When it comes to paying for points on a refinance, you’ll have two possible options: 1) pay for points in cash at closing, or 2) finance the cost of the points into the loan.

If you are interested in buying down your rate, you should speak with your lender before your loan closes. The fee for the points will be paid directly to the lender as part of your closing costs.

When you receive the Loan Estimate document for your mortgage, you’ll see the mortgage points separated as a line-item cost on the top left of page two. Should you see points being charged but you weren’t expecting to pay them, ask your lender for options without points. They can most likely offer you a mortgage without points, but expect a higher interest rate in exchange.

What about negative discount points?

There is another way in which lenders may use discount points – in reverse.

Instead of paying points to get access to lower mortgage rates, you may also be able to receive points from your lender. You could then use the cash to pay for closing costs and fees associated with your home loan.

The industry term for reverse points is a “rebate.”

Mortgage applicants can typically receive several points in rebate. However, the catch is that the higher your rebate, the higher your interest rate.

Rebates are commonly used for refinancing when homeowners want to do a zero-closing cost refinance. This could make sense if you won’t stay, you can stay as liquid as possible with all of your cash in the bank.

Rebates can be great for refinancing, too.

Using rebates, a homeowner may be able do a zero-closing cost refinance. This allows the homeowner to refi without increasing their mortgage balance.

When mortgage rates are falling, zero-closing cost mortgages are an excellent way to lower your rate and payment without paying fees over and over again. You could potentially refinance three times in a year or more and never pay fees to your lender.

How to get the best mortgage rate

If you own a home and haven’t refinanced yet, there is a good chance you’re paying more than you should.

According to Black Knight, many homeowners could still benefit from refinancing. Roughly 13 million could potentially save an average of $283 per month by refinancing. Approximately 2 million homeowners could even save $400 a month.

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But, even though mortgage rates have ticked down, lenders won’t necessarily feel obliged to offer you the lowest interest rate available. Scoring a great rate on a refi usually requires a little effort on your part.

To score the best mortgage rate, take these steps:

·        Understand the breakeven point. The lowest rate isn’t always the best deal, especially if you’re paying too much in closing costs. Refinance calculators can be perfect for this. Be sure to compare all aspects of refinancing, including closing costs, loan discount points and interest rate.

·        Use online comparison sites to shop multiple rates at the same time. This is a great way to get several quotes fast.

·        Apply for with several lenders. Different mortgage lenders offer different rates. The same holds true for paying points. The more you shop, the more you might be able to save. Don’t forget to consider applying with different types of lenders, too. Banks, credit unions and online lenders may offer low rates.

·        Shop within a specific window of time. The credit bureaus encourage you to shop around. They do this by giving you 14 to 45 days, depending on the scoring model, to apply for as many mortgages as you want with the same effect on your credit scores as applying for one loan.

Are loan discount points right for you?

Mortgage points are a great way to pay upfront in order to lower the overall cost of your home loan. But, doing so will lead to higher closing costs.

How long you’ll be in your home is the biggest determining factor when deciding if you should pay points when refinancing. Points typically only make sense if you plan to be in the home for a long period of time.

You should consider all the aspects that could influence how long you’ll stay in your home. Factors such as the size and location of your home, your job situation, your financial position can all influence how long you’ll be in your home, and ultimately whether or not paying points make sense.

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