Just like many investors and homeowners, I was recently considering refinancing a rental property I own. After submitting my application, I received a table of rates available to me. I could get a mortgage with an interest rate around 3.5% with minimal closing costs, or I could choose a lower interest rate if I was willing to pay a larger upfront closing cost for mortgage discount points.
This scenario is undoubtably familiar to anyone who has secured a mortgage before. A lender offers a choice of a “base rate,” or a lower interest rate in exchange for more money upfront. It begs the question—when should you invest your money in a lower interest rate? At what point is it beneficial for the borrower to shell out some additional cash at closing?
To answer this question, I searched for a mortgage points calculator and what I found was terrible! Of the five or so websites I looked at, not a single calculator properly evaluated when to buy down your interest rate on a mortgage. All I found was overly simplistic calculators to mislead borrowers (intentionally?) and benefitted the lending institutions. It frustrated me more that I should probably admit. I could not let that aggression stand, man. The dude does not abide!
I decided, then, to write this explainer on how to properly calculate when to buy points, and even went so far as to make a calculator in Excel. I’m pretty geeked about the calculator. If you’re a BiggerPockets Pro or Premium member, you can access the calculator I created in Excel.
Here’s what we’ll discuss today:
- Buying points can either boost or hurt your returns depending on two primary factors: how long you plan to remain in the loan, and what you would do with your money if you didn’t invest it in mortgage points.
- Using net present value (NPV), we can weigh an investment (buying points) against an alternative investment. When the NPV is positive, the investment will deliver the better return. When NPV is negative, the alternative investment is the better choice.
- The shorter your intended hold, the less likely it is you should buy the points (because you won’t enjoy the benefits of lower monthly payments for long enough to justify the upfront expense).
- The higher your discount rate (the return on your alternative investment), the less likely it is that you should buy points.
What’s a mortgage discount point, anyway?
When you apply for a mortgage, the bank factors in a complex set of factors in determining which rate to offer you. You can see my deep dive on interest rates here, or TL;DR: The federal government, the broader economy, and your personal credit worthiness all play big parts in the interest rate of any given loan.
But the banks have flexibility in what rate they offer you. They offer you a base rate, but then also offer you “points,” or discount points which reduce the interest rate on your mortgage. Every point costs about 1% of the mortgage—so buying a property at $250,000 means one point would cost $2,500.
Buying a point reduces your interest rate by about 0.25% for the lifetime of your loan. For a $250,000 mortgage, you’d pay $2,500 in exchange for a 0.25% reduction in your interest rate over the lifetime of the loan.
Good deal, right? Maybe? Who knows?!
Should I buy points?
Whether or not to buy points comes down to a simple tradeoff:
- Pay more upfront to save money later or…
- Save money now in exchange for higher monthly payments for the lifetime of your loan.
While this seems like a simple matter of personal preference, there is actually a mathematical answer to this. You can actually calculate whether buying points is a better financial decision than taking the base rate.
Note: Many prefer to stick with their personal preference over the mathematical answer, and that is totally fine! My job here is just to explain how you can use math to be a better investor. So even if you don’t apply the concepts in this post to buying mortgage discount points, the concepts I am going to explain below are foundational to investing, so read on!
Banks (and apparently many other finance websites) would like to present this tradeoff as simple to calculate. Just figure out the break even point, they say! Takes these nice shiny points, and don’t think twice about it, they say.
To them, all you have to do is figure out how much buying the points costs you at closing, then divide that by the monthly savings. Voila, you know how long you need to hold a property in order to benefit from buying points.
Let’s use an example to further illustrate this concept.
Let’s say Molly Mortgage is looking at a rental property that costs $400,000. She is putting 20% down, and therefore is taking out a loan of $320,000. For a 30-year fixed mortgage, Molly is offered a 3.5% interest rate, with closing costs of $4,500. This means her monthly payment for principal and interest comes to $1,437.
Alternatively, Molly can buy her mortgage down three points to a rate of 2.75%. This would increase her closing costs to $14,100 but reduce her monthly payment to $1,306.
If the banks and other websites were right, then all we need to do is calculate the break even points. Here’s what you should know first:
- Break even: The cost of points divided by the monthly savings, expressed in a number of months
- Cost of points: The closing costs with points, minus the base closing costs
- Monthly savings: The base monthly payment minus the monthly payment with points.
Here’s how to calculate this in Molly’s example.
- Cost of points: $14,100 – $4,500 = $9,600
- Monthly savings: $1,436 – $1,307 = $129
- Break even: $9,600/$129 = 74 months
So, if Molly holds on to her property for greater than 74 months she wins, right? No! This is the oversimplified math banks want you to use.
As an investor, you need to be thinking about how else that $9,600 could be used if you don’t invest it into buying mortgage discount points. This is where the “time value of money” (TVM) comes in.
Time value of money
If I were to give you the choice between receiving $5,000 today or $5,000 in three years, which would you chose? Most people would say they want the $5,000 today. Who in their right mind doesn’t want cash in hand?
But there is more to this question than the simple desire to have more money today. The reality is that the $5,000 you could receive today is actually worth more than the $5,000 in three years.
Because you can invest it. If you take the $5,000 today and invest it for the next three years—presuming you have positive ROI on your investments—you’ll have more than $5,000 in three years.
This is the idea behind the time value of money: Money today is worth more than the same amount of money in the future.
Let’s continue the example of receiving $5,000 today or in three years to further this idea.
If you chose the $5,000 today, you could take that money and invest it into an index fund that returns 9% per year.
Using the compound interest formula—principal *(1+rate of return)^term—we can see that in three years we would have $6,475.15. By choosing to take the $5,000 now, you are gaining $1,475.15 you would not have if you took the $5,000 in three years.
Put another way, the $5,000 today is worth $1,475.15 more than $5,000 in three years. That’s a big difference!
The time value of money and mortgage points
The time value of money must be factored into the mortgage discount point buying decision. We have to take into account the fact that the monthly savings we enjoy from buying points is not worth the same over the lifetime of the loan. The value of that savings decreases over time!
We need to discount the value of our future cash flow (savings on monthly mortgage payments) to account for what alternative investment we could be making with that cash.
We do this using a very handy financial metric known as net present value (NPV). This allows you to measure the return on one investment, such as buying points on your mortgage, versus an alternative investment—like investing that money in an index fund.
Essential to the NPV calculation is the “discount rate,” which is the rate of return you expect you could generate from an alternative investment. Using our example above, our discount rate would be 9%, which is the return on our index fund.
This number could take on any form, though. If you invest your spare cash in a savings account that yields 2% annually, use that as your discount rate. If you wouldn’t realistically invest the money saved from not purchasing the points, then use 0%.
Best of all: NPV is super easy to interpret. If it’s positive, the primary investment (buying points) is the better option. If the NPV is negative the alternative investment is better. Easy!
Again, we’re not going to get into the details of the math here (after all, I built a calculator for you all to use), but take a look at the table below:
|Month||Expected cash flow||Present value||NPV|
As you can see, each month we have our cashflow. In month 0 (the origination of the loans), our cashflow is -$9,600, which is what it costs us to buy three mortgage discount points. Every month after that we expect cashflow of $130.57 in positive cashflow.
But knowing what we do about the time value of money, we know that that future money is actually worth less than money today, and we therefore need to discount it! We do that with the discount rate and a formula called present value, which you can see in the third column. When we factor in the time value of money, the value of the monthly cashflow declines every month!
Lastly, we get NPV, which is basically the sum of all the values in the “present value” column.
And there we have it—the proper way to evaluate whether or not to buy mortgage discount points. If the NPV is positive on the date you exit the loan, you made the right call. If the NPV is negative when you exit the loan you should have gone with the alternative investment.
To hammer this all home, let’s get back to our example from Molly. When we last left her, she had calculated her break even point at 74 months, using some website that misled her.
Interestingly, using the “other” (wrong) way, the break even point stays almost the same no matter how many points you buy.
But using NPV and calculating this all properly, we see this:
The break even point is actually a moving target, based on your discount rate. As we can see from this chart, the lower the discount rate, the lower the break even point. And that makes sense! If Molly were only earning 1% on her alternative investment, buying the points is a solid investment, and would pay her back in just 76 months.
However, if you’re earning 9% in an index fund like Molly could be, it would take 108 months for Molly to break even.
See how this works? If you could be earning a great return elsewhere, the proposition of buying points becomes worse and worse. And this is true regardless of what interest rate your mortgage is at or how many points you buy:
Sure, the exact break even point—when the line hits zero and NPV becomes positive—depends on the interest rate of your loan, but the pattern is always the same.
So, if this scenario were real life, and Molly were presented these options with a discount rate of 9%, the calculators I looked at the other day would have told Molly her breakeven point was 74 months… when it is really 108 months. That’s almost a three-year difference! This type of discrepancy can make a huge difference in investing returns over time.
Always factor in the time value of money when making an investment—especially if you’re considering purchasing mortgage discount points.
How the lender benefits from points—not you
The reason I said I was angrier than I should be about those shitty simple calculators on other website is because banks are presenting a tool that makes it seem like they are trying to help you. But they’re not. Instead, they’re manipulating people into helping the bank make better profits.
Banks inherently understand the time value of money—that’s their whole business model! The only reason they offer you a discounted interest rate is they can take the money they get from you buying points and lend it out elsewhere.
If Molly bought the points for $9,600, it would get her a 0.75% reduction in interest rate. But the bank is going to take that $9,600 and lend it out for about 3.5%, which is the base rate they offered Molly. They are making money off that spread.
Using Molly’s example, you can see how this works for banks. If she buys the points, the bank is benefitting from day one. As we calculated earlier, it will take Molly 108 months for her to benefit from the deal.
I am not saying that banks offering points is wrong. As we now know, any time after 108 months there is mutual benefit—both the bank and Molly benefit from the transaction. I have no qualms with mutual benefit.
What I resent is banks that offer financial “tools” that claim to help consumers but do the opposite.
To help you decide whether or not to buy points on a mortgage, I made an Excel calculator you can use. As an exclusive part of BPInsights, this calculator is only available for BiggerPockets Pro members—so be sure to join today.
All you need to do is fill in the cells shaded in green and you’ll get a simple yes/no answer to whether you should buy the points based on your discount rate and your intended loan hold.
Here’s a walkthrough of how to use the discount point calculator.
I am overly excited about this thing, and I hope it works for you! You can download it here.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.