Understanding Mortgage Interest Rates + Discount Points

GeneralBuyers

Aug 30

Confidently Navigating the Home Buying Journey

Buying a home is an exciting milestone in life, and whenever you take this step, it’s important to understand some fairly complex financial terms and strategies. Two of these essential terms you want to know and have a solid grasp on how they impact your deal and decisions are:

Interest rates
Discount points (also known simply as “points”)

If you’ve been around our blog long enough, you know we’re big believers that knowledge is power when it comes to making wise, informed decisions with real estate. One of the starting points is to make sure you know the lingo and how it impacts you. So let’s get onto it!

What are Mortgage Interest Rates?

Most of us know what interest rates are. But here’s a quick refresh: The mortgage interest rate is the cost you pay to borrow money from a lender to buy your home. Think of it as the rental fee you pay to borrow the money. It's typically expressed as a percentage of the loan amount and affects your monthly payment and overall costs. The higher the rate, the higher the “rental fee” of the money you borrow.

Fixed-Rate vs. Adjustable-Rate Mortgages

Fixed-Rate Mortgage (FRM)

The interest rate remains constant throughout the life of the loan. It provides stability, making it easier to budget. Because a fixed rate offers more stability for the borrower, they are typically offered at higher rates than their adjustable-rate counterparts. It makes sense, right? Lower risk comes at a price, in this case, a higher interest rate. Like in other areas of life, you pay more for increased safety.

Adjustable-Rate Mortgage (ARM)

This type of interest rate varies according to market conditions. It often starts lower than a fixed rate but can fluctuate, potentially leading to higher payments down the road. Since the great financial crisis of 2008, many of the rules around adjustable-rate mortgages have changed. ARMs of today are not your parents’ ARMs of the past. However, they do tend to carry slightly more risk due to the lack of stability in the payment.

Interestingly, even though adjustable-rate mortgages carry more risk, a 10/1 ARM (which is a fixed rate for ten years) isn’t THAT much different from a 30-year fixed-rate mortgage. Why would that be? Well, because most people don’t stay in their homes for thirty years. On average, people move about every thirteen years, which means many of them are not even in their homes for ten years. Thus, the risk of a 10/1 ARM is not nearly as high as, say, a 3/1 ARM (a fixed rate for three years), where a borrower is much more likely to be facing an adjustment to their rate. A likely rate adjustment with a shorter-term ARM means instability and risk exposure, which means a lower cost in the form of a lower interest rate. The bank is happy to provide a lower interest rate because they are either going to adjust the rate upward, stay at the market rate, or get paid off and get to deploy that capital into the marketplace again.

According to Nerdwallet, as of the date of this writing, the 30-year fixed rate was around 7.3%, the 7-year adjustable rate was 7.277%, and the 3-year was 6.125%. As you can see, the difference between the short-term and long-term fixed periods caused the rates to differ drastically.

Discount Points: What Are They and How Do They Work?

Discount points are a way to buy down your interest rate, effectively paying more upfront to secure a lower interest rate over the life of the loan. One discount point typically equals 1% of the loan amount. Paying for one discount point typically equates to a reduction in the interest rate of .25% - .5%. A lender I spoke to as of the date of this writing was telling me that the cost to bring a client’s rate from 7.5% (going rate) to 6.5% was 2 discount points (aka: 2% of the loan amount, which in this case was about $13,000).

Discount points also work in the opposite direction. The lender will pay YOU points in the form of closing cost credits. (No, they won’t pay you cash at closing, unfortunately). They will pay you points in exchange for a higher interest rate. When rates were extremely low during the COVID-19 era, buyers who didn’t have enough money to pay closing costs or those who wanted to keep some money in their pocket for repairs paid a slightly higher rate in order to get their closing costs covered. Sure, their payment was a little higher, but for a lot of people during that time, going from a 2.75% rate to 3.5% was no big deal.

3 Factors to Consider to Help You Decide Whether to Buy Points

1. Short-term vs. Long-term

If you plan to stay in the house for a long time, buying points might save you money over the loan's life. However, if you plan to sell soon, the upfront cost might not pay off. Buying points is typically done with a simple break-even analysis. For example, let’s say purchasing the discount points costs you $5,000, and the lower rate saves you $500/mo. Well, in that case, you’d have to stay in the home for 10 months or more in order to “break even” – where the months of savings equal the amount you paid out. Every month beyond month 10 in our example is a $500 benefit to you each month. However, if you paid $5,000 and the savings were only $50/mo, it would take you 100 months to break even. So, to gain the benefits of the savings, you’d want to have confidence that you’re going to be in the home for over 8.3 years. For most people, it’s very hard to know what life will look like and if they’ll be in the same home 8+ years later. So, in this situation, you might pass on paying the points.

2. Budget Considerations

Assess your current financial situation and determine whether paying more upfront fits within your budget. Regardless of the aforementioned break-even analysis, if it doesn’t fit in your budget, then the break-even point doesn’t matter. You have to have the cash on hand.

3. Market Conditions

It's wise to consider the current interest rate environment as well. Sometimes, buying points makes more sense when interest rates are high, and sometimes, it makes a lot of sense when they’re lower. However, another big piece of the puzzle is to consider where rates are going to be in the future. If you have good reason to believe that rates will be lower in the future, then paying discount points now doesn’t make sense because you can simply refinance to the lower rate in the future. But be aware that interest rates are notoriously difficult to predict – read more about that on our blog, Why Predicting Interest Rates is a Fool’s Errand. Most interest rate predictions are invariably wrong.

The Relationship Between Interest Rates and Discount Points

Understanding the relationship between these two can help you make informed decisions in your buying experience, particularly as it relates to these factors:

Inversely Proportional: Generally, the more discount points you pay, the lower the interest rate. For example, buying two points might reduce your interest rate by 0.5% - 1.0%.
Negotiation Power: Some lenders allow negotiating the points and rate. For example, you might decide to pay one point for a 0.25% rate reduction instead of the standard 0.5%. This requires careful analysis and might depend on various factors like the lender's policy and the market conditions. Sometimes, in a buyer's market, the seller is willing to give you a seller credit in order to pay your discount points. If you can’t get them to lower the price of the home, see if you can get them to chip in and pay for points. This usually has a larger net benefit to lowering your monthly payment than a price reduction in the same amount!

If you need a realtor to help you navigate all this and more when buying your home, let’s talk.

Always here to help you be more informed so you can get the best deal,

Brent

Brent Edwards (aka Brent the Broker) is a residential real estate agent and Realtor in San Diego, CA who helps clients buy and sell homes in San Diego, California and all surrounding areas. Brent is a highly-recommended Realtor in San Diego by family, friends and past clients. Call Brent today at 619-550-8070 if you have any questions about real estate in San Diego or you'd like to buy or sell a home.