Want a lower interest rate on your FHA-insured mortgage loan? Consider paying points at closing. This one-time, upfront closing cost could give you access to a “discounted” rate, thereby saving you money over the long term.
But “long term” is the key phrase in that last sentence. Paying discount points on an FHA loan is something that tends to pay off after a number of years. It doesn’t work so well for a shorter stay.
Definition: A discount point is basically a lender credit that allows you to make a tradeoff in how you pay interest on your loan. One point is equal to one percent of the loan amount. Some borrowers choose to pay discount points up front, at the closing, in exchange for a lower mortgage rate on the loan. This strategy can be applied to both FHA and conventional home loans.
Note: There are other types of points and credits available to borrowers. This article focuses on the discount point in particular, which is the one borrowers sometimes use to secure a lower rate from the mortgage lender.
Paying Discounts to Get a Lower FHA Loan Rate
As mentioned above, paying discount points on an FHA loan is a tradeoff:
- You’re essentially paying more money up front, so that you might pay less money (in interest) over the long term.
- If you stay in the home and keep the loan long enough, the amount you save (from having a lower monthly payment) will eventually surpass the amount you paid for the point.
- The point at which your accumulated savings begin to surpass the amount paid in points is known as the break-even point. It’s sometimes spelled “breakeven point,” or with the acronym BEP.
How to Calculate the Break-Even Point
To recap, some borrowers pay discount points on their FHA loans in exchange for a lower mortgage rate from the lender. Over the long term, this strategy could save the borrower a significant amount of money by reducing the size of the monthly payments. It can also reduce the total amount of interest paid over the loan term.
But does it make sense for you?
To answer that question, you’ll need to calculate the break-even point (defined above) and think about how long you plan to keep the loan.
There’s a formula you can use the get a general idea of where the break-even point lies. If you divide the cost of the points by the amount you’ll save on your monthly payments, you’ll end up with the number of months you need to keep the loan in order to reach the break-even. Beyond, the break-even point is where you start to enjoy savings.
Here’s that formula again:
Cost of points รท Monthly payment savings = Months to reach break-even
Example Scenario: With and Without Points
Suppose you’re taking out a 30-year fixed-rate mortgage for $400,000, and the lender offers you an interest rate of 4.5% without any discount points. However, you have the option to buy one point for $4,000, which will lower your interest rate to 4.25%.
By buying that one point for $4,000, you’re essentially investing $4,000 upfront to reduce your interest rate by 0.25%. Over the course of a 30-year loan, this can lead to significant savings on your monthly mortgage payments and overall interest costs.
Here’s how the numbers break down:
Scenario without Points:
- Loan Amount: $400,000
- Interest Rate: 4.5%
- Monthly mortgage payment (principal and interest): Approximately $2,027
- Total Interest Paid Over 30 Years: Approximately $331,287
Scenario with One Point (0.25% Rate Reduction):
- Loan Amount: $400,000
- Interest Rate: 4.25%
- Upfront Cost for One Point: $4,000
- Monthly mortgage payment (principal and interest): Approximately $1,967
- Total Interest Paid Over 30 Years: Approximately $306,626
In this scenario, by paying $4,000 upfront to buy one point and reduce your interest rate, you’d save approximately $60 per month on your mortgage payment and about $24,661 in total interest over the life of the 30-year loan. This demonstrates how buying down your mortgage rate with discount points can lead to long-term cost savings, making it a practical financial strategy for homebuyers.
The Four Most Important Concepts to Understand
When it comes to using discount points to buy down the interest rate on an FHA loan, there are four primary components that come into play…
- Mortgage Interest Rate: When you take out a mortgage, the lender offers you an interest rate. This interest rate determines the cost of borrowing money to purchase your home. The higher the interest rate, the more you’ll pay in interest over the life of the loan.
- Discount Points: Mortgage discount points are a way to lower your interest rate. Each point typically costs 1% of your total loan amount. By paying these points upfront at the time of closing, you essentially “buy down” your interest rate.
- Rate Reduction: Each point you purchase usually reduces your interest rate by a certain percentage. For example, one point might lower your rate by 0.25%. The exact rate reduction can vary depending on the lender and the current market conditions.
- Long-Term Savings: Buying down your mortgage rate can result in significant savings over the life of your loan. By securing a lower interest rate, you’ll pay less in interest over the years, potentially saving thousands of dollars.
Pros and Cons of Using Points With an FHA Loan
Using discount points with an FHA loan, like with any mortgage, comes with both pros and cons. Here’s a straightforward and neutral assessment of the advantages and disadvantages:
Pros of using discount points with an FHA loan:
- Lower Monthly Payments: One of the primary benefits of buying down your interest rate with discount points is that it can lead to lower monthly mortgage payments. This can make homeownership more affordable, especially if you plan to stay in your home for a long time.
- Long-Term Savings: By paying upfront for discount points, you can significantly reduce the total interest you pay over the life of your FHA loan. This can translate into substantial savings, potentially outweighing the initial cost of the points.
- Tax Deductibility: In many cases, the cost of discount points may be tax-deductible, which can provide some financial relief come tax season. However, you should consult a tax professional for specific advice on deductibility.
Cons of using discount points with an FHA loan:
- Upfront Costs: The most apparent drawback of using discount points is the upfront cost. Each point typically costs 1% of the total loan amount. For an FHA loan with a high principal balance, this can amount to a significant upfront expense.
- Long Break-Even Period: It may take several years to recoup the upfront cost of discount points through lower monthly payments. If you plan to sell your home or refinance your FHA loan within a few years, the savings from discount points may not materialize.
- Not Suitable for Everyone: Discount points are most advantageous for borrowers who plan to stay in their homes for an extended period. If you expect to move or refinance relatively soon, buying down the rate with points might not be a wise financial choice.
- Reduced Cash Reserves: Paying for discount points at closing reduces the cash you have available for other expenses, such as a down payment, closing costs, or home-related purchases and repairs.
Using discount points with an FHA loan can be a strategic move to lower your long-term interest costs and monthly payments. However, it’s essential to weigh the upfront cost against your expected time in the home and financial goals.
What the Handbook Says About It
Borrowers can pay discount points on FHA loans (which are insured by the government), as well as conventional mortgage loans (that are not insured by the government).
When it comes to the rules and requirements for FHA-insured home loans, we must look to the Department of Housing and Urban Development, or HUD. (The Federal Housing Administration is part of HUD, so it’s HUD that establishes all of the program requirements.) Most of these guidelines are covered in HUD Handbook 4000.1, the Single-Family Housing Policy Handbook.
Here’s what that handbook says about discount points for FHA loans:
- “Discount Points refer to a charge from the Mortgagee for the interest rate chosen. They are paid by the Borrower and become part of the total cash required to close.”
- “Other Fees and Charges: The Mortgagee or sponsored TPO may charge the Borrower discount points, and lock-in and rate lock fees consistent with FHA and CFPB requirements.”
The handbook also states that “interested parties” in the transaction (like the seller, builder or developer) can “contribute up to 6 percent of the sales price toward the Borrower’s origination fees, other closing costs and discount points.”
So there you have it, a crash course in paying discount points for a lower interest rate on your FHA-insured mortgage loan. If you found this article helpful, you might want to peruse our collection of related articles available here.