So you’re thinking about purchasing a home. Big decision. Some people at this point say things like “good for you”, or “now you won’t be throwing money away on rent”. Codswallop. Sometimes you’re financially better off renting. It’s just a fact. People in general would rather own than rent, but that doesn’t alone make it better. You’re also a Thousandaire and you have all of this extra money after putting down a down-payment (if not, you might be better off renting, a great calculator to help you decide is available here). The lender starts talking about “points” should you buy them?
What are points?
Points come in two flavors: discount points and origination points. One point corresponds to 1% of your total loan amount. So if you are buying a $200,000 home and you put 20% down that leaves you with a $160,000 loan and 1 point is costs $1,600. Now for that $1,600 what do you get? Well, for origination points you get the lender to originate your loan. This is basically a fee they are charging you. Sucks. Shop around, but basically if you want the lender to originate the loan you have to pay these. (Like everything else in life it is negotiable!) Discount points are usually what folks are talking about regarding points. You pay that $1,600 and your interest rate gets reduced by some amount (like 0.25% per point or something).
The hope here is that you are able to reduce the interest rate by enough to pay back that money you spent on the discount point. How do we calculate if this is worth it? Well, any reasonable mortgage calculator will be able to tell you what the reduction in monthly payment will be. We can work a quick example. Let’s say that you’re buying that $200,000 house. The interest rate would be 4%, but you purchase a point for $1,600 and the interest rate is now 3.75% ($1,600 might realistically buy you more or less of an interest rate reduction, ask your lender). The payment at the 4% rate is $764, the payment at the 3.75% rate is $741. This works out to a difference of $276 per year.
Naively you might be inclined to simply divide the cost of the point ($1,600) by the annual savings ($276) and figure, “well, if I’m not going to sell the house or refinance for 5.8 years then its a good deal.” The problem with this is that you aren’t considering what that $1,600 would earn you otherwise. At the very least you could earn 4% on that money by applying it to your loan immediately! If we’re a little loose and dirty with the calculation we could just go ahead and figure that at 4% $1600 would produce an “income” of $64 annually. Therefore, let’s go ahead and divide that $1,600 figure by $212 (276 – 64) instead. This means that the break-even point is pushed out to 7.5 years. We can do even better if we assume that the money would be invested in the stock market at a rough rate of return of 8% per year. This gives a break even point of 10.8 years.
So, do I buy points or what?
Probably not. It seems to me that the lender is simply counting on you refinancing or moving within about 11 years. Frankly, I think you’ll move or refinance within 11 years. The, “or refinance” is an important point here. I used to think interest rates couldn’t go lower, yet somehow they continue to march downward. There’s a couple in denmark paying a negative interest rate on their mortgage. There’s a decent chance that at some point in the next 11 years interest rates will be lower. Sure, maybe interest rates will be only be higher, but if you know what direction interest rates will move over then next 11 years, buying discount points on your mortgage has got to be the worst way to profit from your powers of precognition. Of course, this all changes if your lender offers you more than a 0.25% reduction per discount point, but now you have a quick back-of-the-envelope method for figuring if it is in the ballpark of a good idea.
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