There are so many specialized terms in real estate finance. One of the trickier ones that has a real impact on the long-term cost of your mortgage is “discount points,” sometimes referred to as “mortgage points.” If your lender starts describing how to buy down points and you feel lost, don’t worry. We’ll explain all you need to know about discount points, how they work, and their pros and cons.
- Discount points are dollars you spend up front to reduce your interest rate long term.
- The cost of a discount point is standardized: 1 point = 1% of the loan amount.
- Buying points could save you tens of thousands over the life of the loan and lower your monthly payment
What is a discount point?
A discount point is a fee you pay your lender to lower the interest rate on your home loan. Essentially, by buying mortgage points, you “buy” a lower interest rate. For this reason, mortgage points are also referred to as “discount points.”
Discount points are applicable to generally any loan program, including home purchases, home refinances, and fixed-rate and adjustable-rate loans. Points are paid at closing and can sometimes be added into the amount you’re borrowing.
Why would you buy discount points?
As you know, your personal financial situation determines your loan terms. If you have excellent credit, a reliable income, and not too much debt, you’re going to qualify for the best interest rate. Real life is a bit messier for most of us, though, and a lender may offer a rate that is higher than you prefer to pay. If other aspects of your home loan are within your plan and budget, but your interest rate isn’t as low as you’d like, that’s where discount points can be extremely helpful.
Another way to think of it is that by buying a point, you are prepaying interest to obtain a lower monthly payment. Buying discount points to lower your interest rate can save you thousands of dollars over the life of the loan, provided you plan to live in the home long enough to recover what you paid up front for the lower interest rate.
Are discount points and origination points the same?
No, they are not the same. An “origination point” refers to the lender’s origination fee, which is what the lender charges you to process your loan. Origination points have no impact on your interest rate; they’re a separate line item in the overall cost of obtaining a loan.
How much do discount points cost?
A discount point equals 1% of your loan amount. For example, if you have applied for a $100,000 home loan, one mortgage point will cost you $1,000. You can buy multiple points, but most lenders cap the number of points you can buy.
For every point you buy, your interest rate will be lowered by a certain percentage. While points are not always paid in set increments, the average is a .25% rate reduction for each point purchased.
Loan amount: $300,000
Cost to purchase 1 point: $3,000
Is buying points worth it?
The main consideration when deciding whether to buy points is knowing how long before you “break even” on the cost of the mortgage points.
Using our example loan scenario, the savings over 30 years were amazing (over $30,000) but the monthly bill was only lowered by $90 a month. And while $90 per month in your pocket is nothing to sneeze at, you paid $6,000 up front to lower your bill by that amount. So it’s really critical to know how long it will take for your $6,000 investment to pay off.
For our scenario, assuming you make only your scheduled monthly payments, it will take 67 months for you to break even on the cost of those points. That’s 5.5 years. For a 30-year loan, that may be money well spent.
It probably doesn’t make sense to pay for discount points if:
- You don’t have the cash-flow to buy points now. Drawing from your rainy day fund to buy points may take away from your financial flexibility. Extra funds you plan to put toward your home may be better spent applied to the down payment. A smaller loan amount can mean lower interest and a lower monthly payment. Ultimately, it may make more sense to have a higher interest rate and receive a lender credit to help pay closing costs if cash flow is a concern.
- You don’t plan to stay in your home for a long time. If you know you may want or need to move in a few years, discount points are less likely to save you money. It depends on your break-even point.
- You plan to make extra mortgage payments. If you know you’ll be making extra mortgage payments, you should factor this into your break-even analysis. If you’ll pay off your 30-year loan in 20 years because you’ll be making extra payments, that impacts how much interest you’ll pay. You’ll want to run additional break-even calculations to account for your extra payments to see whether paying for points is worth it.
- You know you’ll want to refinance in the near future. Refinancing can be a really smart move when rates drop, especially if you buy when rates are high. But as always, the decision to buy points should be based on how long the loan terms remain the same before you recoup your investment in buying points.
Discount points can lead to major savings
If you stay in your home and make regular payments, and if you have the cash flow to do it, buying mortgage points can be a great way to save a lot of money over the long term. The only way to know if it’s right for you is to do the math. Luckily, there are several reliable, free discount points calculators on the web to make these estimations easy, such as https://www.mortgagecalculator.org/calcs/discount-points.php or https://mortgage-calculator.net/mortgage-points-break-even-calculator.php.
Pros of paying for discount points:
- Potential for huge savings over the life of the loan
- Lower your monthly payment
- You may be able to save on taxes. Mortgage interest is tax-deductible and points are considered prepaid interest, so it’s possible to deduct the cost you paid for the points, subject to current tax laws.
Cons of paying for discount points:
- It takes time to recoup your investment when you buy discount points up front. If something happens and you sell your home or refinance, you may not benefit financially from buying points.
- Discount points apply to adjustable rate mortgages, but after a few years once the initial term is over, the rate adjusts. When that happens, the benefit of buying points may not be worth the investment anymore, depending on how long it takes to recoup the cost of buying points.