A guide to mortgage discount points

As a savvy homebuyer, you already know the importance of shopping around for the best mortgage rate and negotiating prices. But what if we told you there was another step you could possibly take to make your rates even more competitive? Hopefully, your ears have perked up now. 

Today, we'll be discussing mortgage discount points, how they work, how much they cost and how to determine if they’re worth the investment.

What are discount points on a mortgage loan?

Mortgage discount points, also called mortgage points, are fees paid directly to the lender at closing in exchange for a reduced interest rate on a mortgage. The process is often referred to as “buying down the rate.” Each point typically costs 1% of the total loan amount and can lower the interest rate by a certain amount, usually 0.25%, although this can vary based on your lender and market conditions.

Buying discount points can be beneficial if you plan to stay in the home for a long time, as the savings on interest over the life of the loan can outweigh the upfront cost of the points. The break-even point is the point in time when the monthly savings from the reduced interest rate equal the upfront cost you paid for the points.

Mortgage discount points vs. mortgage origination points

You may see the term mortgage origination points on your loan offer. These are not the same as mortgage discount points. Instead, it refers to the origination fees your lender is charging you to process your loan. Unlike discount points, origination points do not reduce the interest rate.

How do mortgage points work, and how much do they cost?

Each mortgage discount point usually costs one percent of your total loan amount, and lowers the interest rate on your monthly payments by 0.25%nerd-wallet-mortgage-pointsnerd-wallet-mortgage-points. For example, if your mortgage is $300,000 and your interest rate is 7.5%, one point would cost $3,000 and lowers your monthly interest to 7.25%. Some lenders may also allow you to buy half points, which would lower your interest rate by 0.125%.

Here’s how buying points might affect your loan over time.

How much is one mortgage point worth to you?

Let’s use the same example as above. With a $300,000 30-year mortgage at 7.5%, one point would give you a new interest rate of 7.25% and an upfront cost of $3,000. The original principal and interest monthly payment would be $2,097.64, and you’d pay $455,151.67 in interest over the life of the loan.

After buying the point, you’d pay $2,046.53 monthly and $436,750.38 in interest over the loan term. You’d save about $51 a month and roughly $18,401 in total interest.

How much is three points on a mortgage?

Now let’s look at the savings if you purchased three points instead of one. With a $300,000 30-year mortgage at 7.5%, three points would give you a new interest rate of 6.75% and an upfront cost of $9,000. The principal and interest monthly payment would be $1,945.79, and you’d pay $400,485.94 in interest over the life of the loan.

That means you’d pay $100.74 less per month and less in interest over the life of the loan for a total savings of $36,264.44.

When considering whether to purchase mortgage points, it's important to calculate the break-even point, which is the time it takes for the savings from the reduced interest rate to equal the cost of the points. This can help you determine if buying points is a financially sound decision based on how long you plan to keep the mortgage.

Are mortgage discount points worth the cost?

As you can probably tell, buying points can save you a significant amount of money each month and over the life of the loan. But does that mean it’s always a good idea to purchase points? To answer this question, it’s helpful to know your break-even point, or the time it will take for your savings to equal your upfront payment.

To calculate your break-even point, first determine how much you’d save on your monthly mortgage payment if you buy points. Then, divide the upfront cost by that amount.

Using the example above, if you bought one point, you’d save $51 a month. If you divide your upfront payment of $3,000 by $51, you would hit your break-even point after 58 months or about five years. Knowing your break-even point can help you determine how much you’ll likely save, especially if you plan to sell or refinancerefinance-hl000061 your home before you reach the break-even point.

Are mortgage points tax deductible?

According to the Internal Revenue Service (IRS), points may be deductible as home mortgage interest. If you’re able to deduct your interest, you may be able to do the same for the points paid on your mortgage. 

However, mortgage discount points are only deductible if your mortgage is being used to buy, build or repair your home. So as a homebuyer, your points may be deductible, but if you’re refinancing and plan to use the money to pay off debt, it may not be.

Talk to a tax professional to learn more about claiming this deduction. 

When is it a good idea to buy points on a mortgage?

While mortgage points can provide some real long-term savings, it may not be right for everyone. Before you buy points, you should consider if any or all of the following apply.

You have cash available after making a full down payment

Buying points may make sense if you have cash to spare after making a down payment of 20% or more. Otherwise, you risk higher costs for private mortgage insurance (PMI). PMI can easily add a full 1% to the cost of your mortgage each year until you reach a loan-to-value ratio (LTV) of 80%. This can easily negate any long-term benefit you’d gain from buying mortgage points.

Your interest rate is considered high

Whether or not your interest rate is considered “high” can be subjective, but mathematically, buying discount points work to your advantage faster when interest rates are higher. In the earlier example, buying one point on a $300,000 loan cost $3,000 and saved $51 per month. But if the interest rate was lower, say 3.5% versus 3.25%, you’d save about $41 monthly, meaning it’d take you longer to reach the break-even point and see a return on your investment.

You plan to stay in your home

If you’re buying a forever home, paying for points can save you money in the long run. However, if you plan to sell or refinance your home within the first five to 10 years, the upfront cost of the points may exceed or equal any long-term savings benefit. Basically, you’ll want to stay in your home past the break-even point to make the cost worth it. 

In summary

If you can afford to put down more money during closing and intend on staying in your home for a long time, mortgage points could help you save a decent amount of money on interest. 

Speak with your Home Lending Advisor today to see what option works for you.