Buying Discount Points to Lower Your Interest Rate
Learn the pros and cons of discount points
Mortgage applicants pay lenders fees for discount points. Lenders offer discount points to applicants as a way to lower their mortgage interest rate. While buying points sometimes lower interest rates, many times, the purchase costs you more than it saves.
The cost of each point is equal to one percent of the loan amount. For instance, for a $100,000 loan, one discount point equals $1,000. Paying for points lowers your interest rate, because the lender receives the income in a lump sum at closing rather than collecting the interest as you make payments on your loan.
Should You Consider Buying Points?
Whether or not paying points makes sense for you depends on how long you plan to keep the loan.
Here's how to use a mortgage calculator to help you decide:
- Calculate the amount of your monthly payment at the interest rate you will be charged if you do not buy points.
- Calculate the amount of your monthly payment at the lower rate if you do pay points.
- Deduct the lower payment from the higher payment to find the amount saved each month.
- Divide the amount charged for points at closing by the monthly amount saved. The result is the number of months you must keep the loan to break-even on paying points.
An Example of Breaking Even
In order to find where break even is for buying discount points, check out the following example.
Let's examine a $100,000 Loan over a 30-year term:
- 7.5% Interest, no points = $699.21 monthly payment
- Buying 1 point for $1,000 = monthly payment $690.68
- Monthly Savings = $8.53
- $1000 / $8.53 = 117 months
Based on the information above, your break-even point is 117 months, or nearly 10 years to recover the cost of buying the discount point, considering only the simple calculation of those funds at today's value. Ultimately, it's best to estimate how long you expect to live in the home. If you plan to own the home for a short period of time, discount points might not be worth the expense.
If you look at amortization schedules to compare the two loans, you'll see that the lower interest rate loan does have a slightly lower principal balance at the end of 117 months, $87,024 versus $87,259 for the 7.5-percent loan. So you might want to consider the savings amount to decide whether to buy points.
Can the Seller Pay for My Discount Points?
Probably. Talk with your lender about what's allowed with your loan. The seller will probably want a higher sales price if paying a portion of your fees, but you can move into the house with less cash at closing.
Are Discount Points Tax Deductible?
Yes, points paid for residential real estate are tax-deductible in the year they are paid. Buyers may deduct the amount paid even if the seller pays for the points at closing.
Are Discount Points the Same As An Origination Fee?
An origination fee is a fee charged to process your loan. It typically costs the same as one point, but it is a different type of fee. Ask your lender if you will be charged an origination fee as part of the mortgage agreement.