Ask an expert: Should you pay discount points on an ARM?

A: When you pay discount points, you pay money, often upfront, to reduce the interest rate on a mortgage and lower your monthly payments. With an adjustable-rate mortgage, paying points will reduce only your initial interest rate (and usually any rate cap based on that rate). But it will not otherwise affect the rate you pay after the first adjustment period. For this reason, paying upfront may not be worthwhile.

In most cases, people choose to pay discount points if they are getting a fixed-rate loan and plan to hang on to it for several years. By electing to pay more upfront, they can enjoy savings in the future with the lower rate. Typically, one point equals one percent of the loan amount and will lower the interest rate by .25 percent.

It usually takes several years, however, to break even when paying points. To understand why, imagine that you have a 30-year, $150,000 fixed-rate mortgage, and you’ve paid two points ($3,000) to lower the rate from 7.5 percent to 7 percent, saving you $50 per month. While your monthly payment is lower, you paid $3,000 for that benefit. You would need to keep that mortgage for five years (60 months x $50 = $3,000) for your monthly savings to at least equal what you paid upfront.

With an adjustable-rate mortgage, however, you may not have enough time to see any savings. For example, in the case of a one-year ARM, your initial rate is in effect for only 12 months, after which it is adjusted annually. If you paid the $3,000 upfront, as in our previous example, you’d only be able to reap the benefit for a year, which is 4 years short of the break-even point.

The situation changes if you are looking at hybrid ARMs, which carry an initial rate that is usually fixed for three or more years. For example, say you are signing on for a 3/1 ARM (the first number is the years the term is fixed, the second is the adjustment interval that applies after the fixed term has expired) and have the option of paying $2,250 to lower your monthly payment by $75. Your break-even point would come at 30 months, and since your initial rate is in effect for 36 months, you may want to consider paying points.

The general guideline is therefore that the initial rate period for an ARM needs to be longer than the break-even period for it to be worthwhile to pay points. Paying points on a 5/1 or 7/1 ARM (where your initial rate remains fixed for five or seven years respectively) is therefore potentially more attractive than on an ARM with a shorter initial rate.

Always be sure to ask your loan officer to explain exactly how paying points will affect your particular mortgage.

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