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.