What Are Discount Points?
You’ve spent years saving up for your dream home, and it looks as if it may finally be time to buy. But mortgage interest rates have been edging up lately, and you’re worried the rate that lenders are willing to offer may stall your plans once again.
When interest rates are too high, some consumers decide to postpone homeownership just a bit longer. But many lenders offer buyers a way to save on monthly mortgage payments by paying an upfront fee — or discount points — in exchange for a lower interest rate.
Discount points have the potential to help borrowers save thousands of dollars over the course of their loan. But with interest rates still low by historical standards, the points may not make sense for some buyers who don’t plan to stay in their new home long enough to break even on point costs. Also, it’s easy to confuse discount points with other terms that buyers might hear when speaking with lenders, like origination points and lender credits.
What exactly are discount points?
Discount points often go by different names themselves. Sometimes lenders refer to them as mortgage points or prepaid interest. The idea, however, is the same: These upfront fees are optional, and are paid to lenders by borrowers in exchange for a lower mortgage interest rate and, as a result, lower monthly payments.
As a buyer, you can expect every point you pay will equal 1% of the amount of your mortgage and that it could lower your interest rate by about 0.25% (interest rate reductions depend on the lender). So, if your mortgage loan is for $250,000 and carries an interest rate of 4.25%, a one-point discount might cost you $2,500 but would also lower your interest rate to 4%.
Discount points can be very attractive to buyers who hope to lock in the lowest mortgage interest rate they can. If you itemize tax deductions, you may also be eligible to deduct the cost of points just as you might be able to do for mortgage interest payments. Here, the IRS gives you the option of deducting the cost of points over the life of your loan or during the same year you purchase them. If you opt for the second option, you’ll have to meet certain IRS requirements, like ensuring the points paid weren’t more than the amount usually charged in your area.
Regardless of why you’re considering discount points, you must consider how long you plan to stay in your home. That’s because it generally takes a few years to recoup point costs, regardless of the size of the loan amount.
Here’s a chart that shows how long it would take for a buyer to break even after paying either one or two points on a 30-year, fixed-rate mortgage for a house that costs $200,000, with a down payment of $40,000 and a yearly home insurance fee of $700. The chart presents three different interest rates:
|Loan term||30 years||30 years||30 years|
|Time to break even||–||6.77 years||6.8 years|
Check your loan estimate to see what kind of point options your lender may be willing to offer you. Your lender should provide a loan estimate after you apply for a mortgage, and by law, the estimate is required to include point options, as well as what discounted interest rates you might receive. Look for the same details in the closing disclosure that lenders are required to provide you three days before you close on your home. You’ll actually pay the points when you close, along with other costs like title insurance, real estate commissions and any transfer fees.
While shopping for the best possible mortgage for you, you may run into another type of points: origination points. Origination points — also called origination fees — are the mostly administrative fees lenders charge borrowers for services like processing a loan. Origination points and fees will add to closing costs, but unlike discount points, will not benefit a borrower.
Lender credits, like discount points, can also save a homebuyer money, and your lender may mention them as well. With lender credits, you can expect to pay lower closing costs in exchange for a higher interest rate on your loan. However, also expect to pay higher monthly mortgage payments.
Lender credits are also calculated as 1% of the total loan amount. According to the Consumer Financial Protection Bureau, a 1% lender credit may even appear on your loan estimate as a negative one point.
Even when lender credits are an option, many homebuyers simply ask a seller to pay closing costs.
Should you buy discount points?
With the recent rise in mortgage interest rates – and home prices still rising in many parts of the country – buying discount points is an option some buyers may now find more attractive than just a few months ago.
“Now is not a bad time to purchase discount points, especially if you plan on staying in your house. Since rates are historically low, you may never see a rate this low again,” said Shaun Thompson, sales manager at AmeriSave Mortgage Corporation in Atlanta.
While speaking with a lender, you’ll most likely be encouraged to review several factors to help you determine if purchasing discount points is ideal for you. This is because the discount may not always save you as much as you hope. Thompson cautions buyers to weigh the cost of the discount points before making a decision.
Let’s say you purchase a $250,000 home and the loan term on your $200,000 mortgage is for 30 years, but you decide to sell or refinance after owning the home for just four years. If the interest rate on your mortgage was 5%, and you also purchased two discount points at $2,000 each (for a final interest rate of 4.5%), you would have to stay in your home for at least five and a half years before breaking even on $4,000 in point fees.
Paying for points may make more sense if you have a 15-year (rather than 30-year) mortgage, because you are more likely to stay in your home for that length of time.
For some buyers, it may also be wise to simply increase the down payment they plan to put on a new home. For example, if you’re thinking of putting down less than 20%, you might be required to buy private mortgage insurance (PMI) and that could wipe out any benefit from buying points.
Before purchasing, consider the following:
Pros of buying discount points:
- Reduction of mortgage interest rate
- Savings on monthly mortgage payments
- Decrease in the total cost of the home loan
- Potential tax deduction
Cons of buying discount points:
- Higher closing costs
- Home may need to be owned for many years before owner can break even
- Loss of money on discount points due to selling of the home or refinancing prior to breaking even
Before purchasing discount points, be sure to answer these questions:
- How much will each discount point cost?
- How much will you save on monthly mortgage payments?
- How long do you plan on living in the home?
- Is the cost of the discount points immediately affordable?
- Will you break even on this cost before you sell your home?
- Can a different lender offer you a comparable interest rate without points?
The bottom line
It’s natural to get excited about the prospect of saving money on a large investment like a new home. If a mortgage lender offers an option to purchase discount points, you will most likely be able to lower your monthly payments, although the amount will be less for smaller mortgages and may not be as much as you expect. With discount points, the real payback will come once you’ve lived in your home long enough to defray what may be a potentially large upfront cost. Review your individual circumstances carefully before you commit. To see what your mortgage costs might be overall, check LendingTree’s mortgage calculator.