Discount Points Ain’t Worth It

A reader asks:

I am looking to refi, an ARM. Contacted [XYZ Mortgage Company]. They offered an interest rate [—] on a 7 yr ARM. However, they want to charge me $6300+ in Loan Discount Fees. Is this normal, or legal?

This is a multi part question. First of all, charging discount is legal. I wouldn’t say it is normal, but many brokers do make it a habit of charging a discount. A discount is what you pay a lender in exchange for a lower interest rate. It is different from an origination point.

I don’t know the exact situation this person is in, so I won’t use his numbers to explain things. The bottom line is that for the average borrower paying a discount is usually never worth the cost unless the break even is less than three years. It can be useful tool for investors though. That is for another day.

Allow me elaborate on my thinking. Lets suppose that on a $200,000, 30-year loan you are looking at 6.375% with 1.00% discount or 6.625% with no discount (I’m using today’s rate sheet). The chart below shows how things break down:

  Option 1 Option 2
Loan Amount $200,000 $200,000
Interest Rate 6.375% 6.625%
Monthly Payment $1,248 $1,280
Discount Rate 1.000% 0.000%
Discount Charge $2,000.00 $000
Payment Difference   $33
Break Even Point   60.8 months

The break even point in this case is over five years. So, it might be worth it to some people, personally if it was my loan I wouldn’t. This is because if you end up re-financing this loan before that time then you will lose the potential saving. An important thing to keep in mind is that the average person re-finances within four years and moves within seven. Even though you may think you will not re-finance, the chances are you will.

Going back to the readers question, to justify paying a discount charge of $6,300, the monthly savings has to be at least $175 on a $200,000 loan to keep the break even point at 36 months. A $175 per month savings can only be achieved with a 1.5% difference in rate and from my understanding that kind of rate buy down is very expensive especially on an ARM. So, if you’re not buying your rate down down by at least 1.5% then it’s not in your best interest to pay this charge.

Bonus link: Mortgage Mechanics Part 1 of 10

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