Bigger Down Payment vs. Paying Points
Which is Better?
When getting a home loan, you have numerous decisions to make and expenses to pay. If you have the option to pay points, you may wonder if that cost makes sense, and how to budget your dollars between your down payment and any points.
Both expenses will come out of your pocket up front (unless you finance the points), so the immediate impact on your budget is identical. Likewise, both points and a down payment can reduce your required monthly mortgage payment. However, over the long term, they affect your finances in different ways.
As a quick refresher, let’s review the difference between points and a down payment. Then, we’ll evaluate when one option might be better than another.
Discount points lower the rate on your loan. In exchange for a payment today, your lender will reduce the interest rate on your debt. This is sometimes called “buying down the rate” on your loan because you’re effectively purchasing a lower rate.
To be more precise, you might say that you’re paying interest early, and your lender is adjusting your interest rate accordingly.
Interest costs cannot be recovered—you won’t get the interest back when you sell. As a result, you need to benefit from that expense in other ways (and make sure the numbers add up). There are several potential ways you can benefit from paying points, including:
- Potential tax benefits from the money you spend on points
- A lower monthly payment, resulting in a more comfortable cash flow situation in future years
- A lower rate on debt over the years (if you keep the loan long-term)
A down payment is an amount you pay up front towards the purchase price of a property. This amount reduces the size of your loan and represents your ownership interest in the home (increasing your equity). You are the owner of any home you own, but your lender may have liens on the property until you pay off all of your debt.
Making a down payment is similar to using your home as a piggy bank. The home acts as a store of value: Assuming the home does not lose value, you can get that value back when you sell the property. Alternatively, you can borrow against that value with second mortgages or use that value as collateral for other needs.
Your Payments With Points and Down Payments
Both discount points and a larger down payment will lower your required monthly mortgage payments. Monthly payments are calculated using a few factors:
- The interest rate
- The loan amount (also known as the balance)
- The loan’s term (or length of time that the loan is scheduled to last)
If you reduce any of those items, the monthly payment will also go down. In addition, the amount of interest you pay will also decrease. Interestingly, you can keep the loan amount level, but reduce total interest costs by lowering the rate or shortening the life of the loan.
Different inputs lower your payment, but they do it in different ways. The best way to see this is to experiment with a loan calculator or use amortization tables to evaluate different loan alternatives. Most importantly, look at the interest costs over time, and over the life of the loan.
What Should You Do?
With a better understanding of how the payment and interest costs change with each option, you should have an easier time evaluating your lender’s options (and deciding what to do with your cash).
If you have the cash available and you plan to stay in your home for a long period of time, points are worth a look.
- Estimate how long you’ll really keep your loan. With a longer period, you may be better off paying points and paying interest at a lower rate.
- Check the breakeven period on your points: Figure out how much you’ll save each month on your payment, and calculate how long it will take to recoup the amount you spend up front. Then, remember that your total interest costs may also be different if you pay points.
- Explore the potential tax impacts with your tax advisor. Paying points might give you a deduction today, and that may be more beneficial than interest savings in future years. Don’t forget that interest costs may also be deductible — but spending money for a tax deduction is still spending money.
- Evaluate alternative uses for the funds, and decide if you should do something besides put the money towards your home.
- Decide if you think you’ll be able to refinance at a better interest rate in the somewhat near future. If your credit scores or income improve, you might qualify for a better loan. Likewise, look at interest rates and whether or not you expect them to rise, fall, or stay level.
- Run the numbers on financing points. Rolling points into your loan balance is typically not as advantageous as paying out-of-pocket, but it may be worth a look.
Use a points calculator to determine how much you’ll benefit from paying points. Then, compare those savings to a smaller loan (using an amortization table). For example, on a $300,000 loan, evaluate the savings that come from a lower interest rate if you pay two points (or $6,000). Then, see how the loan looks if you only borrow $294,000—adding that $6,000 to the down payment instead of putting it towards points.