What Are Discount Points?
Discount points are a type of prepaid interest or fee that mortgage borrowers can purchase that will lower 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.
- Discount points, or mortgage points, are prepaid interest payments that borrowers can choose to pay so as to lower the interest on future payments.
- Discount points are a one-time fee, paid upfront at either the time a mortgage is first arranged or during a refinance.
- Points don't always have to be paid out of pocket; they can sometimes be rolled into the loan balance, especially during a refinance.
- Discount points are a good option if a borrower intends to hold a loan for a long period of time, but less useful if a borrower intends to sell their property or refinance before they are able to break even on the extra upfront payment.
Understanding Discount Points
Discount points are also known as mortgage points. They are a one-time, upfront mortgage closing cost that gives a mortgage borrower access to discounted mortgage rates as compared to the market. Because the Internal Revenue Service (IRS) considers discount points to be prepaid mortgage interest, they are tax-deductible only for the year in which they were paid.
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%. Depending on the length of the mortgage at this interest rate, this could result in significant savings over time. This would ideally be suited for a fixed-rate 30-year mortgage that most likely wasn't going to be refinanced anytime soon.
How to Pay for Discount Points
Reducing your mortgage interest rate with discount points does not always require paying out of pocket; particularly in a refinance situation where 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 their equity position in their 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 their interest rate for free.
Benefits of Discount Points
Both lenders and borrowers gain benefits from discount points. Borrowers benefit from lower 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 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.
At the end of the day, for a borrower, the benefits of discount points depend on the math. 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.
Lenders always benefit from borrowers that wish to pay for discount points because lenders receive cash upfront instead of having to wait for money in the form of interest payments over time, which enhances the lender's liquidity situation.