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Paying mortgage discount points: a primer

Bob Walters is willing to shell out cash to get a rock-bottom mortgage interest rate. That's why he always pays discount points.

"I have never, in my history of being in the mortgage business, gotten a mortgage when I didn't pay points," says Walters, the chief economist for Quicken Loans. "If you know you're going to be in a mortgage four or five years, it always makes sense."

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Should you pay discount points when you get a mortgage? To answer that question, you have to guess whether you'll keep the mortgage past the break-even point -- the time when your accumulated monthly savings exceed the amount you paid in points.

"If you're going to be in that mortgage longer than the break-even point, you win," Walters says. "If you aren't in that mortgage longer than the break-even point, you lose."

Mortgage discount point defined
Lenders say that a lot of customers -- especially first-time home buyers -- don't understand the concept of discount points and feel reluctant to ask. One discount point is an upfront payment of 1 percent of the loan amount, paid at closing. You receive a reduction in the interest rate in exchange for paying discount points. You end up with a lower monthly mortgage payment.

Discount points are based on the loan size, not the purchase price. If you borrowed $200,000 to buy a $300,000 house, one point would cost 1 percent of the loan amount, or $2,000. Two points would cost $4,000. Paying discount points doesn't reduce the amount borrowed.

As a rule of thumb, the mortgage's interest rate is reduced by a quarter of a percentage point for every discount point you pay. That's just a rough guide, though; the actual amount of the discount varies by lender and can fluctuate in response to movements in the bond markets. One day a lender might drop the interest rate by a quarter-point in exchange for a discount point; the next day, the same rate reduction might cost only half a point. Most lenders give the option of paying anywhere from half a point to four discount points or even more.

Estimating your break-even point
To find out whether you'll hold the mortgage past the break-even point, you must have a notion of how long you will keep the mortgage. If you plan to sell the house or refinance within two years, it probably doesn't make sense to pay discount points. On the other hand, if you plan to keep the mortgage for 10 years or more, you'll save money in the long run by paying points.

The time in between can be trickier. One way to figure it out is to ask your mortgage lender to prepare a chart outlining some of your options.

In the accompanying table, the zero-discount-point option is the best deal through the fifth year. A borrower who plans to live in the house for five years or fewer, or who plans to refinance the mortgage within that period, should go ahead with the zero-point option.

But soon after the five-year mark in the above scenario, the advantage goes to loans where the borrower paid discount points. After 10 years, the borrower saves a total of $1,880 by paying one discount point up front. After 30 years, the borrower saves almost $38,000 by paying four discount points.

Next: "Don't let the tax tail wag the financial dog."
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