What if a lender offered you a lower interest rate on your mortgage, or even cash toward your closing costs? It may sound too good to be true but it actually happens on a regular basis, in the form of discount points and premium credits, respectively. It sounds great but it’s also important that buyers understand what they’re signing up for when they look at these options.
“Discount points” are based around the idea of the buyer paying extra upfront in return for a lower interest rate on their mortgage payments for the lifetime of the loan. A premium credit is almost the exact opposite, when a mortgage provider pays funds toward the closing costs of a home in return for the buyer agreeing to a higher interest rate.
These both sound great, and they certainly can be, if you have a solid plan for the future. It’s important to think ahead, however, otherwise signing up for one of these options can come back to bite you. Let’s look at two cases, one for both discount points and premium credits, in order to understand the math that all potential buyers should consider.
A discount point is defined as 1 percent of your loan amount, so it differs from mortgage to mortgage. Let’s assume, for this example, that you’re taking out a loan on a $340,000 home. That means one discount point is worth $3,400.
The way this system works is that you’ll pay one discount point—or an additional $3,400—in return for a lower interest rate on the mortgage. One point is typically worth .25 percentage points. In this case, your rate lowers from 4 percent to 3.75 percent after you pay for the point.
How can you determine if this will ultimately work out to your benefit? It all depends on how long you plan on being in the home. Here’s a formula for determining whether a discount point system is a good value for you:
(Value of Discount Point) / (Amount Saved on Monthly Payment) = Number of Months
In this case, you’d divide $3,400 by $48 (how much you’d be saving on a monthly basis for this loan). This comes out to 71 months. That is the number of months it will take for this opportunity to pay off on your behalf. That’s about six years…so if you plan on moving out in less than six years, DON’T buy into a discount point. If you plan on being here for more than 10 years, it’s almost a no-brainer.
As we mentioned, a premium credit is when the lender pays you to take a higher interest rate of your mortgage. The way of determining whether it’s a good deal for you works in very much the same way.
Let’s look at the same house. If you move in with a 4 percent interest rate, you’ll owe $10,000 in closing costs. However, if you agree to take a premium credit—upping your interest rate to 4.875 percent—then you won’t need to pay any closing costs.
Here’s the formula you’ll need to see if you win in this situation:
(Amount of Money Saved at Closing) / (Additional Amount Paid on Monthly Payment) = Number of Months
In this case, you’ll divide the $10,000 you save upfront by $150, which is how much extra you’ll pay per month with the higher interest rate. That will come out to 67 months.
Now remember: This formula is working in reverse of the last. You win if you stay in the home LESS than 67 months. So if you stick around for more than 5.5 years, that 4.875 percent will come back to bite.
Primary Mortgage Residential wants to help you get into a new home, and we offer a variety of resources to help you understand the financial process and how to get the best deal on your way to that home. Use these options to get expert tips on home-buying and shopping for loans.
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