During the mortgage process, there are many factors to take into account and many financial calculations to be made. When analyzing your budget for all fees and payments involved in the home purchase, the down payment is one of the biggest considerations- being that it is an up front cost. Deciding whether in your case a larger down payment or using mortgage points will be the best approach, requires you to take a peek into your future to see which option may be the better one for you in the long run. Both a down payment and mortgage points can minimize your monthly loan payment, but they impact your finances differently.
What are mortgage points and how do they work?
Mortgage points work similar to a discount: Points, valued at 1% of your mortgage amount or at $1,000 for every $100,000, are fees paid to the lender during closing and serve as a way to lower your interest rate, and lower monthly loan payments overall. Using points is also known as “buying down the rate.” If you plan on owning your home for a long time, points are a helpful way to reduce interest on your mortgage.
Is it worth it in your case to buy points? Will you break-even? By using the formula below you can better evaluate if using mortgage points will be beneficial throughout the term of your loan:
Cost of the points ÷ Monthly payment savings = Months to break-even
Potential cost effective benefits linked to buying points:
- Tax benefits from the money spent on the points
- Reduced monthly mortgage payments
- Improved future cash flow
- A lower rate on debt in the upcoming years on a long term loan.
What is a down payment?
A down payment is an amount paid up front towards the purchase price of a property to reduce the loan amount and secure the value being borrowed.Your equity increases with a down payment, and you are considered the owner of your home, but with possible liens by the lender on your property until all debts are paid off to help ensure repayment of the loan. The down payment amount required depends on your loan type and lender requirements. The amount you’ll be required to put down on a house depends on the type of loan you get and lender requirements. Usually, mortgage lenders ask for 3% to 20% down payments in cash from borrowers for the loan to be approved.
How are monthly payments calculated?
Monthly payments are calculated by:
- The interest rate
- The loan amount (AKA: The balance)
- The loan’s term
If any of those factors are reduced, your monthly payment and interest will go down as well. Larger down payments will also help lower monthly payments. Loan calculators allow you to enter your information and estimate your monthly payments to evaluate your best options. Look closely at the interest costs over time and during the loan term.
What should you choose?
Once getting a better grasp on how the monthly payments and interests costs differ with each option, deciding how to use your cash for the home purchase will become more clear and will help you choose which route being offered by your lender will be best.
How long will you be keeping your loan? Using points are usually a good approach to consider when you intend on staying in your home for a long time to help reduce your monthly payments and your interest rate. Calculate how much you will be saving monthly and how long it will take to break-even on the amount spent buying the points. Note that total interest costs may vary with points and down payments. Speak to your accountant to evaluate tax benefits and potential deductions. Interest costs may also be deductible, but take into account that it means spending money first to quality.
Evaluate other investments you can allocate this money for to make sure it’s within your budget to use it for a home purchase and mortgage. If your credit score and financial status are likely to improve over time, think about whether you will be able to refinance for a lower interest rate or a better loan in the upcoming years. Are interest rates expected to rise, drop, or stay the same? Check up on interest rates forecast and predictions while making your decision.
It is also possible to finance points: Discuss this choice with your loan officer to see if it will a good option to add points to your loan amount, even though it won’t provide all the same benefits as paying up front, out of pocket.
By using the loan calculator and the points formula you can evaluate different options with your mortgage expert to compare side by side what your loan term will look like if you pay with points, or with a down payment. Assess options with varying interest rates and loan amounts to pan out your options and ultimately choose the path that will be the most comfortable financially, and the most beneficial long term.