Should You Purchase Discount Points for a Mortgage? The Answer May Surprise You!

I've seen a bombardment of hate comments and negative sentiment regarding the purchase of discount points for both refinances and new home purchases. I think an educated discussion could certainly settle this perpetual debate because the math isn't mathing for me when people say it's a terrible decision.

I should preface this with the fact that most homeowners tend to stay in their homes for 11-12 years. If you search a New York Times article from this year, you can find where that information is referenced. While this number has been dropping and is an average, this is a good baseline to begin this post with.

Life is about income, is it not? Everyone would like more income. But the inverse of that is we also don't really want a lot of debt or debt payments, unless that debt payment is an asset and generates cash flow (which is a whole other part to this discussion for investors).

Assuming most people, including long-term investors, hold their homes well past the breakeven point or the recoup period. Why on earth would you not want greater cash flow or less expenses for that period? There is an infinite possibility of what that money could do for someone including greater discretionary spending and/or increased deposits in an investment account. So let's break down what the process is to analyze a good discount point purchase from a bad one so that mortgage loan consumers can better analyze the options they are getting and decide for themselves what makes sense. I'm going to give a few examples for you to see.

I'm going to use a few constants for these examples to explain it better. One constant is annualized ROI. The S & P 500 has had approximately 10% ROI over the past 50+ years. We aren't posting this in wallstreetbets, let's be practical. The majority of people aren't getting 20+% ROI year-over-year. Another constant will be a 10-year hold period. We can argue hypothetical situations all day long so let's set the parameters to something realistic from the beginning. Another constant is that we are acting in our knowledge today. Not our knowledge from the past or our assumptions of what we think will happen in the future. We can't change the rates of the past and I don't know a single person who has a crystal ball of the 10-year treasury bond market.....

Example 1: A VA homeowner purchases a property with a 6.625% interest rate with the intention to hold. The original loan amount is $350,000 for a 30-year fixed VA Loan. I will exclude taxes and insurance, so P & I comes out to $2,241.09. Let's say that homeowner, one year later want's to refinance to the best rate possible as rates have gone down significantly in that year. One year later, that original balance has declined to $346,179.83. 

Lender A:

Our new loan amount to close without any money out of pocket will be $352,000. The par rate at the moment for a VA IRRRL loan is 5.75%. Total closing costs excluding escrow and prepaids is $3,702.10. This what we use to determine if the loan will recoup in 36-months or less. This excludes the VA funding fee because that is excluded from this calculation for these types, and the veteran is also 100% disabled. P & I would drop to $2,054; a decrease of $187.09. Now let's divide that $3702.10 by the $187.09 and we get our par rate recoup period. That leaves us with 19.78 months to recoup the cost of this.

Now let's purchase some discount points because we can include up to 2% of points if it will fit the recoup of 36 months. Let's say we buy the rate down to 5.25%. The total cost on this is really contingent on how the originator is compensated, but in this example, the broker is paid by the lender and that compensation is priced into the interest rate. The total loan balance would increase to $359,000. Let's say the total fees have gone up $5,385 because that originator wants to maximize comp. while also buying down the rate as much as possible within this deal. The added fees are $5,385 to buy down the rate .5% and the P & I drops to $1,982. So to recoup this loan in 36 months based on the total cost of the refi, we are limited to a total of $9,327.24 in closing costs and fees, excluding the above exclusions. With this deal, it penciled out to $5,385 plus the additional $3,702.10 in normal fees and closing costs that are associated with the refinance at PAR rate to come out to $9,087.10. If we divide that $9,087.10 by $259.09. Then we get a 35.07 month recoup. But let's take this a bit further. Take the total points purchase of $5,385 and divide by the difference of the two monthly payment savings of 259.09-187.09 or $72. That's gives you a 74.79 month recoup on the "purchase" of discount points.

Here is where people fail to see the value in a 74.79 month recoup or even a 36-month recoup. If we input the $72/month deposit into a future value calculator for 10 years at a 10% interest rate, the final value after 120 months is $14,745.46.

Take that $5,385 and input that same value in the calculator with no additional monthly deposits: $14,571.64.

The refinance with the points purchase still wins at a 10 year hold if the monthly savings is invested. I shouldn't have to show the difference in value if we showed the future value of the two refi payments invested over 10 years, but I will. If we look at the future value of the par rate savings invested at 10 years or 187.09 a months, we get: $38,315.67.  If input the total savings with the points paid, or 259.09 a month: $53,061.13.

Just for terds and giggles, I'll include the total investment if the total in fees was invested without any additional monthly deposit. Original investment amount: $9,087.10 and the future value will be...... $26,710.88. Less than half of the total if you refinanced today..... so what in the hell are you waiting or.

And that's just for the recoup of the fees OF NO MONEY OUT OF THEIR POCKET. Unrealized equity due to appreciation in the home shouldn't be considered in this because it is a constant regardless of buydown, but let's look at the total loan balance difference over time between par rate refinance and the buydown refinance at 10 years. The par rate (5.75%) loan balance after 120 months of payments, originally starting at $352,000, is now down to $292,582.92. The points paid rate (5.25%) loan balance, originally starting at $359,000, is down to $288,457.94.

Example 2: I'm going to show conventional refinance because that's what a lot of people are probably asking about right now. Let's say a conventional homeowner with an original loan balance of $328,000 had a payment of $2,237.54 with a 7.25% interest rate. They wanted to get it down to the lowest possible rate that makes sense while not costing too much out of pocket. They have a 740 credit score and comp will be lender paid in the same way as the previous example. The original loan amount one year later is $324,825.43. 

The refinance will be assuming no new appreciation from the original purchase price of $410,000. We will refinance the new loan to $328,000 again to not add mortgage insurance, but we want to also limit out of pocket expenses. The par rate for this loan is 6.499% which would bring the monthly P & I down to $2,073 and a total monthly savings of $164.54. Total fees on this loan would cost them $5,563.54. This would give the total recoup of all fees at 33.81 months for a par rate refinance, while minimizing cash out of pocket due to the increase back to 80% LTV.

Now let's add some discount points to this scenario. Lets say the client had up to $10,000 to pay for discount points. When it was priced out with the maximum possible for up to $10k, the total cost for the points to drop the rate to 5.625% was $9,794. That would drop the payment to $1,888 and the total recoup on the points purchase would be 52.94 months. That is shown by taking the $2073 and subtracting $1,888 to get the monthly savings difference of $185. When you look at the total recoup for the point purchase, the total fees/closing costs were $14,937.78 excluding prepaids and escrow. If we take the original payment of $2,237.54 minus the $1,888 we get $349.54. Divide the total fees/closing costs of $14,937.78 by the $349.54 and you get 42.74 months to recoup. That's not terrible for the value difference, but let's look at what happens when you invest the savings.

Now let's look at that money savings invested over 10 years. If we didn't purchase the points and invested that $9,794 for 10 years at a 10% annualized return you get: $26,502.25

If you invested the difference of payment from the par value refi and the discount point refi with no additional starting investment: $37,887.64

If you invest the entire $349.54 a month in savings: $71,585.11

If you invested the total cost in fees for the refinance or $14,937.78: $40,421.15

And let's look at the balance on the new loan at 10 years with the interest rate of 6.499%: $278,058.72

Now let's look at the balance on the new loan at 10 years with the interest rate of 5.625%: $271,689.83

No matter how you show it, this makes sense for someone holding these properties to the average and sometimes well short of the average like in 4 or 5 years. We could show this even investing in a high yield money market account and it makes sense. If you consider the potential for them to also cash flow more in the future due to the property being converted into a rental, then by all means every dollar you pay in points makes sense if the math makes sense to your hold period.

Some wholesale lenders will do promotions for discount points and thus make the buydown recoup even more enticing. If your originator isn't a crook, then they may actually show this to you and explain the way their origination charge is priced in this. Or they may show that charge on a line in that quote and take less and get you a better deal because of regulations limiting their compensation for certain types of loans or in general transparency to their clients. This is the value of getting more than one mortgage quote, in writing, with someone like a broker so they can actually look at pricing across many different lenders. Not every lender will make as much sense for a buydown, but that's the point in shopping.

If your loan originator doesn't want to do this math for you, they are being lazy or ignorant. This took more time for me to type this than it did to do the math for 20 of these deals. They all apply the same way whether it's cash out of pocket or rolled into the loan. Take the total fees excluding escrow and prepaids and divide by the difference in payment. If that recoup makes sense versus what you average in annualized return in investments, do the refi and invest the difference.

If you are negotiating for a new home purchase, and your decision is between seller contributions for closing costs towards discount points and fees or a price reduction, TAKE THE DAMN DISCOUNT POINT PURCHASE. Unless you are purchasing the house to flip it or sell within 5-7 years, the equity in that home isn't nearly as liquidable as the cash difference you are saving in payment and hopefully investing for your retirement.

Again, this analysis is case by case with each lender and each scenario for purchase or refinance being completely different, but if you intend to hold anywhere past 5 years, which most people do, it's definitely important to consider discount points. Plus, who in the hell wouldn't want a lower interest rate on their debt obligations unless they are also the holder of the note (most people are with their retirement accounts and they would never know it).

Thanks for reading! Hopefully I generated some insight into some of the benefits of discount points because I'm exhausted from all of the financial illiteracy.