It's no surprise that the San Francisco Bay Area is an expensive real estate market.…
Some home buyers in California choose to pay mortgage points at closing, in exchange for a lower interest rate. This strategy can pay off over time, by reducing the monthly payments as well as the total interest paid.
But what is a mortgage discount point? And when does it make sense to pay them, when buying a home in California? Here’s what you need to know.
Paying Mortgage Discount Points in California
Within the context of mortgage lending, one “point” equals 1% of the loan amount. For instance, on a California home loan of $400,000, one point would come out to $4,000.
In many cases, borrowers opt to pay points at closing in order to secure a lower interest rate on their mortgage loans. This is why they are also referred to as “discount points.” You are paying a certain amount up front to receive a discounted, or reduced, interest rate from the lender.
You can think of it as a form of prepaid interest. You are giving the lender some cash upfront to get a lower rate over the long term. It’s an upfront investment that could lower the long-term costs of your loan, depending on how long you stay in the home.
On average, a single discount point will reduce the mortgage rate by a quarter of a percent (0.25%). But this amount can vary, so be sure to ask about it if you’re considering the strategy.
When Does It Make Sense to Do This?
We’ve covered the basic definition of a mortgage discount point: It equals 1% of the loan amount. It’s a way to reduce your interest rate.
But when does it make sense to pay them? This will come down to two things:
- how much money you have to pay up front
- how long you plan to keep the loan
If you only have enough money to cover your down payment and closing costs, then the point strategy probably won’t work for you. That’s because it would require you to pay extra at closing.
On the other hand, if you have some extra cash set aside, you might be in a position to “buy down” your interest rate. This could potentially save you thousands of dollars over the life of the loan, depending on how long you keep it.
When considering mortgage points in California, you have to determine when you will reach the “break-even point.” This is where the money you save on your monthly payments (by reducing the interest rate) begins to exceed the extra amount you paid at closing (in the form of points).
Example Scenario: Doing the Math
Let’s say you decide to pay discount points at closing to lower your rate. You learn that it will reduce your monthly payments by $50 per month. In order to achieve this monthly reduction, you have to pay $1,200 in mortgage points.
These are the two items you need to calculate your break-even point. You paid $1,200 extra at closing to reduce your monthly payment by $50 a month. You are now ready to do the math.
If we divide 1,200 by 50, we get 24. This means it will take 24 months of monthly savings to reach $1,200. Two years into the repayment term, your monthly savings will add up to the amount you paid in mortgage points at closing. So everything beyond two years amounts to savings.
After two years, you will be paying $50 less per month than you would have if you didn’t purchase any points at all. Thus, the benefits of this strategy increase over time, starting at the two-year mark.
Your long-term plans are the key to all of this. Ideally, you would hold onto the loan long enough to reach your break-even point. That’s the key to using the mortgage point strategy in California.
Additionally, you need to consider your cash reserves. When you pay points up front, you are reducing the amount of cash you have on hand. If you have plenty of additional funds or reserves, this might not be a concern for you. On the other hand, if those extra points are going to wipe out your savings, you’ll want to tread carefully.
Disclaimer: This article provides a basic overview of mortgage points in California and how they work. Every lending scenario is unique, because every borrower is unique. As a result, portions of this article might not apply to your particular situation. Please contact us if you’d like to receive a mortgage estimate or rate quote.