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
Discount points are also known as mortgage points. They are a one-time, upfront mortgage closing cost which gives a mortgage borrower access to discounted mortgage rates as compared to the market. Because the 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%.
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.