Each of these items is a cost that comes out of your pocket up front, so they seem quite similar. To your current budget, they’re identical. However, over the long term you’ll find that they do very different things.
Let’s start by pointing out that discount points lower the rate on your mortgage loan while a down payment lowers the amount of your mortgage loan. Again: we’re talking rate vs. amount.
How Loan Payments are Calculated
You should remember that loan payments are made up of several moving parts. Your interest rate, loan amount, and term (or length of time) determine what your monthly payment will be. If you change any one of these components, you’ll change the monthly payment. More importantly, you’ll also change the total interest cost to the borrower.
If you’re creative, you’ll find the best loan by changing more than one of the components. Try some exercises on our mortgage calculator. You’ll see that lowering the rate lowers your payment as well as your total interest costs over time. The same thing is true if you lower the loan amount. They both lower your monthly payment but they do it in different ways.
For every dollar you have in your bank account, you have a choice. Should you spend it on points, should you apply it to your down payment, or neither?
Discount Points
You can read a more detailed description of discount points in other articles. The general idea is that you “buy down” your interest rate. Because your interest rate determines (in part) your monthly payment, a lower interest rate leads to a lower monthly payment.
A dollar spent on points tends to benefit you over the long term because you’ll have time to make up for the cost today. However, when you pay points those dollars are gone for good because you bought the benefit of a lower rate.
Down Payment
Your down payment is the amount that you pay for your new home. This is the amount you already have saved up and which will represent your equity (or ownership) in the home.
Making a down payment is similar to using your home as a piggy bank. Unlike paying points, the money is not gone for good. You can take it back assuming that your home’s value doesn’t drop. Of course there are always costs.
Which is Better?
As with most things in life, it depends what you want. Here are some general rules of thumb:
- If you’re planning to keep your home for a long time, you may be better off buying points
- If you need a tax deduction today, you may want to use points
Remember that there’s no free lunch. If you pay points, it doesn’t really change the lender’s risk – we’re talking about a 2-3% difference in the loan amount at risk. However, it does change the structure of the loan and somehow it changes your payment. How can this be? They’re using your prepaid dollars for other investments.
You can take a page out of the lender’s book and figure out what your alternatives are with that money. Sometimes paying points is a great idea. Before you decide, crunch some numbers on how things would work with and without points.
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