Shopping for a mortgage brings a flood of new terms, and discount points are among the most misunderstood. Let’s break down what discount points mean, how they work, and whether paying for them makes sense for your home loan.
Discount Points Explained
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Discount points are upfront fees you pay to a lender at closing to lower your mortgage interest rate. Think of it as prepaying some of your loan’s interest: you spend more now to save money every month for the life of the loan.
One discount point equals 1% of your total loan amount. If you’re borrowing $300,000, one point would cost $3,000. In exchange, your lender lowers your interest rate—typically by 0.25% for each point, though the exact reduction can vary.
How Do Discount Points Work?
When you opt to buy points, you and your lender agree on a lower rate in return for the extra upfront cost. Here’s a quick example:
- Loan amount: $300,000
- Current interest rate: 7%
- One point costs: $3,000
- New rate after one point: 6.75% (assuming a 0.25% decrease)
By paying $3,000 upfront, your monthly payment decreases. Over time, the lower interest means you save more on interest than you paid for the point.
Why Pay for Points?
Discount points make the most sense if:
- You plan to stay in your home long-term.
- You want to keep monthly payments as low as possible.
- You have extra cash now and prefer to save later.
If you sell or refinance before reaching the “break-even” point, you might lose money instead of saving it.
Calculating Your Break-Even Point
Your break-even point is when your interest savings match the cost of the points you paid. Use this formula:
Break-even (months) = Cost of Points ÷ Monthly Interest Savings
For example:
- If one point saves you $50 per month and costs $3,000:
- $3,000 ÷ $50 = 60 months (5 years)
If you’ll keep your loan for at least 5 years, buying one point pays off. Leave sooner, and you spend more than you save.
Pros and Cons of Buying Discount Points
Pros:
- Lower monthly mortgage payments
- Huge interest savings over the loan’s life
- Potential tax deduction (ask a tax professional)
Cons:
- Higher upfront costs at closing
- May not break even if you refinance or sell early
- Lender point reductions vary—always check your specific quote
When Should You Consider Discount Points?
Buying points isn’t always smart. Here’s when it might work:
- Staying put: If you know you’ll live in your home for 7-10 years or more, points can save you thousands.
- Extra cash: If you have funds to spare after your down payment and moving costs, points are an investment.
- Long-term loans: On a 30-year mortgage, the savings add up more than on a shorter loan.
But if you’re tight on cash or unsure how long you’ll stay, paying extra upfront can be a risk.
Other Mortgage Choices: Lender Credits
Lender credits are like the opposite of discount points. With lender credits, you agree to a slightly higher interest rate, and in return, the lender reduces your closing costs.
It’s a trade-off: you pay less at closing, but your mortgage payments are higher for as long as you have the loan.
Tax Tips on Discount Points
The IRS often sees discount points as prepaid interest. If you itemize deductions and the loan is for your main home, you may deduct points in the year you pay them. Restrictions may apply, so check with your tax advisor to see if you qualify.
Tips for Comparing Loan Offers
When shopping for a mortgage, compare offers with and without points. Ask each lender:
- How much does one point reduce the interest rate?
- What is the exact cost for the rate reduction?
- How long will it take to break even on the upfront cost?
- Can lender credits offset other closing costs instead?
Get estimates in writing, and do the math for your unique situation.
Conclusion
Mortgage discount points can offer savings, but they aren’t for everyone. If you plan to stay in your home for several years and have the funds available, buying points could reduce your total interest and monthly bills.
Before signing, ask about your break-even point and consider your future plans. Making the right choice can save you money and stress in the long run. Ready to talk with lenders or your mortgage advisor? Ask them about discount points and how they fit your homebuying goals.