What Are Discount Points?

Discount Points Explained in 5 Minutes or Less

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Discount points enable you to make tradeoffs in how you pay for your mortgage and closing costs. Specifically, they lower your interest rate in exchange for an upfront fee.

Discount points are typically paid at closing to bring down your mortgage interest rate in the long term. Consumers who want to pay less interest overall and who intend to pay off a mortgage loan for many years can often save money with discount points. 

Whether zero, one, or more discount points make sense for you and your mortgage loan depends on a number of factors, including how long you plan to keep your mortgage loan. In this guide, learn how to evaluate discount points and decide if they are the best option for your mortgage loan.

Definition and Example of Discount Points

Discount points are a way to prepay interest on your mortgage loan in exchange for a reduction in your interest rate. Following the upfront cost, you receive a lower interest in exchange, and therefore pay less over time.

Discount points are calculated in relation to the loan amount, and one point will generally cost 1% of the total loan amount. So, for example, it would be $2,000 per discount point on a $200,000 mortgage. The lender reduces your interest rate in exchange, often by a quarter or so of a percent per point, although it can vary.

Let’s say that you're offered a $200,000 mortgage at 5% interest for 30 years. You know that you can reduce your mortgage rate to 4.5% by buying two discount points at closing for $4,000. This reduction will save you more than $4,000 in interest costs over the life of the loan, so you decide to buy those points. When deciding whether or not to purchase discount points, it is important to consider whether you're likely to refinance at some point in the future, and whether you want to live in the house for a long time. 

Discount points are prepaid interest, so they're generally deductible on your federal tax return if they meet Internal Revenue Service (IRS) rules. This can also increase their value for your overall financial strategy.

  • Alternate name: Points

How Discount Points Work

Many lenders are happy to offer discount points because they're an upfront cost. They receive their payment ahead of time and they don’t have to worry about waiting for that portion of the interest to come in over the course of the loan. 

Discount points can benefit the borrower if you plan to live in your home long term, as it will bring down your mortgage interest rate. 

But several things can change for a borrower over the course of long-term loans like mortgages. You may actually pay more interest than you would have paid with the higher interest rate if you purchase points at closing, then end up selling your house within five years of buying it. The longer you intend to keep the loan, the more the interest rate reduction stands to benefit you. 

You may not "break even" on that interest cost if you quickly refinance your mortgage for a lower rate because you won’t be refunded any of your discount points. It may be worthwhile anyway if you have a great reason to refinance, but discount points might not be the best choice for you if you know that you would consider refinancing down the road. 

To make sure that this type of deal is good for you, calculate how much a larger mortgage balance will raise your payment and the associated loan costs before signing up. Also, generally consider:

  • How much you want to lower your monthly payment by
  • How long you plan to stay in the home you purchase
  • Whether you’re taking out an adjustable or fixed-rate loan
  • What the tax deduction will look like
  • What your credit history looks like, as it must be good enough to qualify you for the lowest rate available

Another consideration is to make sure that the discount points are “bona fide.” Any points you pay should actually bring down your interest rate, not cause additional fees on your closing costs. In general, the exact amount that your interest is reduced will depend on the lender and market conditions, too.

Do I Need Discount Points?

Buying points can be valuable when your seller has offered to pay a certain amount of your closing costs. Talk to your lender about how many discount points you could buy while sticking fairly close to the amount of closing costs the seller is willing to pay. You also can buy partial discount points, if that works better for your circumstances. 

Alternatives to Discount Points

There are many alternatives to discount points, including refinancing your mortgage when you qualify for a lower interest rate, if your main goal is to save on interest. 

You’ll pay a lower cumulative amount of interest on your loan if you pay down your mortgage quickly with extra payments, provided that you don’t incur any prepayment fees. Paying discount points usually doesn’t make sense if this is your plan. You'll reap more benefits from prepaying interest if you’re paying on the loan for a longer term.

Key Takeaways

  • Discount points are prepaid interest that's delivered at closing in order to reduce your interest rate on a mortgage loan.
  • Choosing to purchase discount points can be a better deal than paying a higher interest rate over the full term of a mortgage loan.
  • If you expect to refinance or sell your home in the short term, or in under 10 years or so, discount points may not be the best option for you.