Two ways you can save on a mortgage are putting more money down and buying discount points from the lender. Each discount point costs 1% of the principal and lowers your interest rate 0.25%. The same holds true for a refinance, where you could put more cash toward paying off your old loan (borrowing less in the new loan) or use the money to buy discount points.
Which is a better use of your cash?
On the one hand, each discount point you buy saves lots of money in interest. On the other hand, putting more money down lowers your debt and gets you closer to the 20% equity milestone when you can stop carrying private mortgage insurance (PMI). The average range for PMI is 0.5% to 2.25% now, according to NerdWallet. For our comparison below, we used 1.75%.
Running the numbers can be fascinating. You adjust your down payment and interest rate and watch the PMI, payment, and total interest change. You could use many free calculators and templates, such as this online PMI calculator or the Loan Amortization Schedule available in Excel.
In this article we take you through a typical mortgage scenario with $6,000 cash in play. Should we use it toward our down payment or buy discount points? What are the short- and long-term pros and cons?
Let's run some numbers to find the answer.
About Discount Points
You might wonder why someone would pay 1% now to save 0.25% on interest. It's because if you plan to own the home at least 10 years, you'll save money. You reach a breakeven point relatively soon. The money you save each month soon covers the cost of the point, and after that you enjoy pure savings.
Here's an example: Let's say you buy one discount point on a $300,000 fixed-rate loan; the point costs you $3,000 (1%). This point entitles you to a drop in interest rate, from 2.95% to 2.70%, for the 30-year term of the loan. If you hadn't lowered your interest rate, your payment would have been $1,257. With the discount point, your payment is $1,217. You're saving $40 a month, which means you break even with the cost of the discount point in 75 months (3,000 divided by 40)—that's just a little over six years. After that, you keep saving $40 every month for almost 24 more years.
Bigger Down Payment vs. Discount Points
In this scenario, you'd like to buy a $325,000 home using a 30-year fixed-rate mortgage. You qualify for 2.75%. You have saved up $31,000 for the down payment, and you also have cash to pay the closing costs (typically 1.5%). Your down payment drops the amount you're borrowing to $294,000 and puts you 60 months away from 20% equity.
You wonder what the benefits might be of shaving $6,000 from the down payment and buying discount points with it. Your down payment drops to $25,000. Your loan amount becomes $300,000 and puts you 65 months away from 20% equity. Since each discount point costs 1% of $300,000, you can buy two for $6,000. The points have the effect of dropping your interest rate from 2.75% to 2.25%.
Equity and PMI: Until you own 20% of the home, most loans (not VA loans) require you to cover the lender's risk by buying private mortgage insurance. A larger down payment gets you more equity up front, shortening both the cost and duration of PMI. The key equity milestone is 20%. If you have 20% for a down payment, then keep it that way—don't shave any off for discount points.
Here is our decision side-by-side. Note: Since both options would include very similar homeowners insurance premiums and property tax, we have not shown those.
|
$6,000 more down vs. discount points (30-year fixed) |
MORE DOWN | DISC PTS |
|---|---|---|
| Home | $325,000 | $325,000 |
| Down | $31,000 | $25,000 |
| Loan Amt | $294,000 | $300,000 |
| Disc Pts | 0 | 2 @ $3,000 |
| Int. Rate | 2.75% | 2.25% |
| Closing | $4,410 | $4,500 |
| Payment | $1,200 | $1,147 |
| PMI/mos. | $429/60 | $438/65 |
In a nutshell, putting more money down has the following pros and cons.
- PROS
○ More equity sooner
○ Slightly lower closing cost
○ Slightly cheaper PMI premium
○ Shorter PMI term - CONS
○ Higher interest rate because no disc. points
○ Higher monthly payment
○ Higher total interest
Buying discount points with some of the down payment money has the following pros and cons.
- PROS
○ Lower interest rate
○ Lower monthly payment
○ Much lower total interest paid - CONS
○ Slightly higher closing cost
○ Slightly higher PMI premium
○ Longer PMI term
Winner: Discount Points
The winning option is to buy discount points. Total interest you would pay is where the difference is most dramatic.
|
$6,000 more down vs. discount points (30-year fixed) |
MORE DOWN | DISC PTS |
|---|---|---|
| Total PMI | $25,862 | $28,196 |
| Total Int. | $138,000 | $112,920 |
Discount points are the clear winner. Because they lowered your interest rate 0.50%, those two discount points end up being a great investment over the life of the loan. Admittedly, the closing cost was $90 higher because you put less money down, but your payment dropped $53, so you offset the higher closing cost in just two months. You also had to pay PMI five months longer ($2,334 more in total).
But you save $25,080 in interest!
The more-money-down option would have cost you $138,000 in total interest, but since you bought discount points instead, you only paid $112,920. It's amazing: You borrowed more money but paid less each month and a lot less in total interest. That's the power of discount points.
Buying discount points to lower your rate pays off. This contradicts the commonsense advice, "Always put as much down as you can afford." If you can afford to shave enough off your down payment to buy two discount points, the short- and long-term benefits can be surprising and substantial.
Takeaways
- Buying discount points often pays off better than a larger down payment would.
- Because discount points lower your fixed interest rate, you keep saving long after the points have paid for themselves.
- If you've got 20% down, though, stick with it to avoid PMI, a major savings.
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