Mortgage Points vs. Down Payment: Buying Down Interest Rates

When it comes to home loan affordability, your interest rate has a huge impact on your monthly mortgage payments. It is common (and highly recommended) that you take time prior to applying for a mortgage to improve your credit score and debt-to-income (DTI) ratio, because it can help you secure a lower interest rate. But those are not the only strategies for obtaining a great rate.

There are two more factors that can have an effect on the rate you are approved for; your down payment and buying mortgage points. While both require up-front payments at closing, they will have different effects on your finances in the long-term. That is why we are breaking down what you need to know about the impact down payments versus mortgage points will have on your finances, so you can determine which option is right for you. 

What are mortgage points?

Also known as discount or buydown points, mortgage points can be used by homebuyers to offset the cost of a mortgage. In essence, they are prepaid interest, or interest fees, that you pay at closing in exchange for a lower interest rate and monthly payments. Not only will buying mortgage points reduce your rate, but other benefits also include:

• Possible tax benefits and reductions

• Reduced monthly payments

• Less spent on interest over the life of the loan

How does buying discount points work on a mortgage?

Though you will save on interest in the long run, mortgage points will cost you up front at closing. One discount point is equal to one percent of your total loan amount. For example, if you are taking out a $300,000 home loan then one point will cost $3,000.

However, one mortgage point does not equal a one percent rate reduction. Instead, for every one mortgage point you buy, your rate will typically decrease by approximately 1/8 to 1/4 of a percent. Your lender, mortgage type, financial history, and current interest rate fluctuations will all be factors that impact the exact percentage reduction you get. Your mortgage points will be listed on your loan estimate, and you pay for them at closing along with any other fees, costs, and your down payment.

How does your down payment affect your interest rate?

Aside from buying down your mortgage rate with points, the amount you provide for your loan’s down payment will also affect your monthly payments for years to come. The minimum amount required to close will depend on the type of mortgage you are using, but it may be worthwhile to take time and save up to put more down. This is because your down payment represents your initial investment in your home. Not only will a larger down payment help you secure a lower rate, but it can offset other costs as well.

For example, if you are able to provide a 20% down payment on a conventional loan, you can avoid paying for private mortgage insurance (PMI). Other benefits of a larger down payment include:

• Lower total loan amount and monthly payments

• Increased equity and ownership stake in your home

• Better loan terms (lower interest rate and reduced mortgage insurance)

From the viewpoint of your lender, a larger down payment indicates that you are a serious and motivated buyer. It also decreases the financial risk they face providing the loan, which is why lenders are more likely to offer you a mortgage with a lower rate.

Mortgage points versus down payment

Before you decide to buy points or add more cash to your down payment fund, it is important to carefully consider the numbers. A 20% down payment can have a bigger impact on your payments than buying down your rate, but beyond that threshold, your down payment’s impact begins to decrease. So, it starts to make more sense to invest in mortgage points rather than increasing the size of your down payment.

On the other hand, if you do buy mortgage points, you will need to hit the break-even period in which the initial cost of the buydown is paid off. This length of time will vary depending on how many points you buy, but it means that you need to plan to live in your home long enough to actually break even.

Which option is right for you?

Your monthly mortgage payments are calculated based on your interest rate, loan amount, and the loan’s terms. Taking measures to reduce any of these items will also lower your payments and the total amount of interest you will end up paying over the life of the mortgage.

If you do not plan on living in the home you are buying for enough years to break even, then buying mortgage points may be a waste of funds that you do not end up recouping. On the other hand, a large down payment may not be plausible with your current homebuying budget. However, if you are motivated to buy now and do not want to take more time saving up for a larger down payment, then buying down your rate can be a great option for saving more in interest in the long run.

It is best to consult with your lender, as they will be able to run the numbers and help you better determine which strategy will benefit you the most. It may even end up making sense for some people to provide both a larger down payment and purchase mortgage points. As long as you know that whatever you decide to do will result in a net benefit, you will be well on your way to buying with confidence.