What are 'Discount Points'

Discount points are a type of prepaid interest or fees mortgage borrowers can purchase that lowers the amount of interest they have to pay on subsequent payments. Each discount point generally costs 1% of the total loan amount and depending on the borrower, each point lowers the loan's interest rate by one-eighth to one one-quarter of a percent. Discount points are tax deductible only for the year in which they were paid.

BREAKING DOWN 'Discount Points'

For example, on a $200,000 loan, each point would cost $2,000. Assuming the interest rate on the mortgage is 5% and each point lowers the interest rate by 0.25%, buying two points costs $4,000 and results in an interest rate of 4.50%.

How to Pay for Discount Points

Buying down a mortgage interest rate with discount points does not always require paying out of pocket. Particularly in a refinance situation, the lender can roll discount points, as well as other closing costs, into the loan balance. This prevents the borrower from having to come to the closing table with money but also reduces his equity position in his home.

A borrower who pays discount points when purchasing a home is more likely to have to come out of pocket to meet these costs. However, many scenarios exist, particularly in buyer's markets, in which a seller offers to pay up to a certain dollar amount of the buyer's closing costs. If other closing costs, such as the loan origination fee and title insurance charge, do not meet this threshold, often the buyer can add discount points and effectively lower his interest rate for free.

Benefits and Drawbacks of Discount Points

Both lenders and borrowers gain benefits from discount points. Borrowers get lowered interest payments down the road, but the benefit applies only if the borrower plans to hold onto the mortgage long enough to save money from the decreased interest payments.

For example, a borrower who pays $4,000 in discount points to save $80 per month in interest charges needs to keep the loan for 50 months, or four years and two months, to break even. If the borrower thinks he might sell the property or refinance his loan before 50 months have passed, he should consider reducing what he pays in discount points and taking a slightly higher interest rate.

Lenders benefit from discount points by receiving cash upfront instead of waiting for money in the form of interest payments over time, which enhances the lender's liquidity situation.

RELATED TERMS
  1. Discount Rate

    The interest rate charged to commercial banks and other depository ...
  2. 100% Mortgage

    A mortgage loan in which the borrower receives a loan amount ...
  3. Origination Points

    A type of fee borrowers pay to lenders or loan officers to compensate ...
  4. Roll In

    A term which refers to including loan costs into the initial ...
  5. Key Rate

    The specific interest rate that determines bank lending rates ...
  6. Market Discount

    The difference between a bond's stated redemption price and its ...
Related Articles
  1. Personal Finance

    Fed's Discount Rate

    The Federal discount rate is the amount of interest a central bank charges private banks for short-term loans.
  2. Personal Finance

    How Do Mortgage Lenders Get Paid and Make Money?

    When homebuyers educate themselves on how mortgage lenders get paid and make money, they are more likely to save thousands of dollars on their mortgages.
  3. Investing

    Discounting With The Discount Rate

    The discount rate is the interest rate you need to earn on a given amount of money today to end up with a given amount of money in the future. Let's say you need $1,000 one year from now to go ...
  4. Personal Finance

    Score a Cheap Mortgage, Here’s How

    Hidden costs can create what looks like a good deal. Find out how to find the best mortgage possible.
  5. Investing

    Financing Basics For First-time Homebuyers

    If you're looking to get your first mortgage, there are many financing options available.
  6. Personal Finance

    Reduce Interest With An All-In-One Mortgage

    "Offset" mortgages combine a checking account, home-equity loan and mortgage into one account.
  7. Investing

    Financial Institutions: Stretched Too Thin?

    Find out how to evaluate a firm's loan portfolio to determine its financial health.
  8. Personal Finance

    Top 6 Mortgage Mistakes

    These common errors could end in foreclosure.
  9. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
RELATED FAQS
  1. How does a high discount rate affect the economy?

    Find out what would happen if the Federal Reserve decided to set a very high discount rate, the rate at which banks can borrow ... Read Answer >>
  2. How do central banks impact interest rates in the economy?

    Learn how central banks such as the Federal Reserve influence monetary policy in the economy by increasing or decreasing ... Read Answer >>
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ... Read Answer >>
  4. What is PMI, and does everyone need to pay it?

    Also known as "Primary Mortgage Insurance," PMI is the lenders (banks) protection in the event that you default on your primary ... Read Answer >>
  5. Why does the loan-to-value ratio matter?

    Learn how the loan-to-value (LTV) ratio is calculated, and why this metric is important to lenders when evaluating a home ... Read Answer >>
Trading Center