Mortgage discount points are an optional fee that some borrowers choose to pay to their lender in exchange for a lower interest rate for their mortgage loan.
As a general rule, paying for points might be a smart idea if you plan to keep your mortgage for many years. If you plan to sell or refinance within a short timeframe, paying for points may not make sense.
What are discount points on a mortgage?
The term “points” refers to an upfront fee that’s based on a percentage of the loan amount. One point equals 1%, so for a loan amount of $400,000, one point would equal $4,000.
Points can be fractional amounts, such as one-eighth, one-quarter or one-half of one point, as well as whole numbers. For the same $400,000 loan amount, 0.5 points equals $2,000, while 1.5 points equals $6,000.
A loan that requires you to pay discount points should give you a lower rate than a loan that doesn’t require you to pay discount points if the loan is the same in all other respects and is originated by the same lender.
Paying more points should lower your rate more than paying fewer points, but the same number of points doesn’t necessarily result in the same discount with every lender or for every type of loan. Rather, the amount of the discount may vary depending on other factors specific to the lender and trends in the mortgage market.
How to decide
It’s not always easy to determine whether paying for discount points makes sense. These four tips may help you decide.
Tip 1: Prepare a breakeven analysis
A breakeven analysis compares the cost of your discount points to your monthly savings from your lower rate. This analysis can help you figure out when your total savings will equal your upfront cost.
As a general rule, paying points may be more attractive if you’re planning to keep your home and your mortgage for at least a few years after you recoup your upfront cost.
A breakeven analysis is generally more useful if your loan has a fixed rate rather than an adjustable rate.
Don’t try to compare your breakeven analysis with a fixed rate to your breakeven analysis with an adjustable rate. This approach isn’t a valid comparison.
Tip 2: Consider your cash position
You can pay for discount points upfront in cash, along with your . But if your cash is limited or you’re planning to make a lot of repairs or improvements to your home right away, you may not want to pay discount points upfront.
Two other options are to finance discount points as part of your loan amount, which may increase your payment or interest expense, or negotiate for the seller of the home you want to buy to pay discount points for you.
Tip 3: Consider your income tax situation
Mortgage discount points may be tax-deductible if you itemize your deductions when you file your federal income tax returns. This tax deduction could help you pay less tax. Your tax savings may be a factor in your breakeven analysis.
Tip 4: Reassess your desired loan amount
Paying for points may help you qualify for a larger loan amount because your monthly payment typically will be cheaper with a lower rate than it would be with a higher rate. If your income isn’t high enough for you to qualify for the loan amount you want, paying for points may be a solution.
Discount points or temporary buydown?
A temporary buydown that lowers your rate for a few years after you buy your home isn’t the same as paying points to obtain a lower rate for the full term of your loan.
A temporary buydown may save you money for a few years, but once the introductory rate expires, your payment may be significantly higher. This is known as “rate shock.” You may be able to at a lower rate, but that’s not guaranteed.
“Should I pay for discount points” is a complicated question since you have to consider your upfront spending, future costs, breakeven points, and more. Do your best to think about your plans for the future and run the numbers to make sure you feel comfortable with your monthly payment before you decide to pay points — or not.