The Ins and Outs of Mortgage Discount Points

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 up front to pay less later, in effect. Discount points are tax deductible.

Understanding Discount Points

A type of mortgage points, discount points are a one-time, up-front 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-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 longer the life span 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 Mortgage 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 the title insurance charge, do not meet this threshold, then the buyer can often 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 coughing up more money at the closing table; of course, it also reduces their equity position in their home.

Can You Negotiate Mortgage Points?

Points are definitely open to negotiation. The number of points you buy—or whether you buy any at all—is up to you. Typically, when lenders are displaying the mortgage options for which you qualify, they’ll show you several different rates, including the ones that you can get if you purchase discount points.

Strictly speaking, you’re not negotiating the points themselves but a lower interest rate for the life span of the loan. The terms of the points—the cost of each point, and 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, then they might match it—especially if you have a strong credit history and seem like a responsible, desirable client.

Should You Buy Discount Points?

For lenders, discount points have a distinct advantage: They receive cash up front, 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 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, then they should consider reducing what they pay in discount points and taking a slightly higher interest rate.

In general, the longer that you plan to own the home, the more that 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 up front, then 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.