What Are Discount Points?
Discount points are a type of prepaid interest or fee that mortgage borrowers can purchase to lower the amount of interest on their subsequent monthly payments—spending more upfront to pay less later, in effect. Discount points are tax-deductible.
- Discount points are a form of prepaid interest that mortgage borrowers can purchase to lower the interest rate on their subsequent monthly payments.
- Discount points are a one-time fee, paid upfront at either the time a mortgage is first arranged or during a refinance.
- Each discount point generally costs 1% of the total loan and lowers the loan's interest rate by one-eighth to one one-quarter of a percent.
- Points don't always have to be paid out of the buyer's pocket; they can sometimes be rolled into the loan balance or paid by the seller.
- Discount points are a good option if a borrower intends to hold a mortgage for a long period of time, but less useful if a borrower intends to sell their property or refinance before the loan matures.
Understanding Discount Points
A type of mortgage points, discount points are a one-time, upfront mortgage closing cost that gives the borrower access to a discounted interest rate for the lifetime of the loan. Each discount point generally costs 1% of the total loan amount and each point lowers the loan's interest rate by one-eighth to one one-quarter of a percent.
For example, on a $200,000 loan, each point would cost $2,000. Assuming the interest rate on the mortgage is 4.5% and each point lowers the interest rate by 0.25%, buying two points costs $4,000 and results in an interest rate of 4.0%. Depending on the length of the mortgage at this interest rate, this could result in significant savings over time. Let's look at how the payments play out on such a loan—assuming the classic, 30-year mortgage:
|The Effect of Paying Points on a $200,000, 30-Year Mortgage|
|No points||1 point ($2,000)||2 points ($4,000)|
|Annual Percentage Rate (APR)||4.5%||4.25%||4.0%|
|Monthly Payment Savings||--||$29.49||$58.54|
|Breakeven Time to Recover Point Cost||--||68 months||68 months|
|Total Savings Over Loan Lifetime||--||$10,616.40||$21,074.40|
The longer the lifespan of a loan, the more you pay interest on it—that's how financing works in general. So points are ideally suited for a fixed-rate, long-term mortgage (20 to 30 years) that most likely isn't going to be refinanced anytime soon.
How to Pay for Discount Points
A borrower who pays discount points is likely to have to meet these costs out of pocket. However, many scenarios exist, particularly in buyer's real estate markets, in which a seller offers to pay up to a certain dollar amount of the 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 their interest rate for free.
Reducing your mortgage interest rate with discount points does not always require paying out of pocket—particularly in a refinance situation, in which the lender can roll discount points, as well as other closing costs, into the new loan balance. This prevents the borrower from cough up more money at the closing table; of course, it also reduces their equity position in their home.
Because the Internal Revenue Service (IRS) considers discount points to be prepaid mortgage interest, they generally are tax-deductible over the life of the loan. If they and the home purchase meet certain conditions, they can be fully deductible for the year in which they were paid.
Can You Negotiate Mortgage Points?
Points are definitely open to negotiation. The number of points you buy—or even if you buy any at all—is up to you. Typically, when lenders are displaying the mortgage options you qualify for, they'll show you several different rates, including the ones you can get if you purchase discount points.
Strictly speaking, you're not negotiating the points themselves, but a lower interest rate for the lifespan of the loan. The terms of the points—the cost of each point, how much it lowers the annual percentage rate (APR)—are pretty much fixed by the financial institution. But they aren't set in stone. If you've shopped around (always a good idea when mortgage-hunting) and can show them a better deal elsewhere, they might match it—especially if you have a strong credit history and seem like a responsible, desirable client.
Although both are types of mortgage points, do not confuse discount points with origination points. Origination points are fees that lenders charge for finalizing a mortgage—part of the closing costs on a home purchase. Essentially a surcharge that doesn't relate to the interest rate, origination points generally aren't optional, negotiable, or tax-deductible.
Should You Buy Discount Points?
For lenders, discount points have a distinct advantage: They receive cash upfront, instead of having to wait for money in the form of interest payments over time. This can enhance the financial institution's liquidity.
Borrowers also gain benefits from discount points—the main one being, the lower payments over the life of your loan. Basically, you are paying some interest in advance—at the onset of your mortgage—in exchange for a decreased interest rate down the road. However, this benefit applies only if you plan to hold onto the mortgage long enough to save money from the smaller 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 they might sell the property or refinance their loan before 50 months have passed, they should consider reducing what they pay in discount points and taking a slightly higher interest rate.
In general, the longer you plan to own the home, the more points help you save on interest over the life of the loan. At the end of the day, though, the benefits of discount points depend on the math. If you can afford to shell out a few thousand more upfront, they can result in significant cost savings over the long term, particularly if the home requires renovations. Or they can be an unnecessary cost that the borrower could have avoided with some more structured planning.
Internal Revenue Service. "Topic No. 504 Home Mortgage Points." Accessed July 5, 2021.