When you shop for mortgage quotes, you’ll encounter two-part rates. The first part is the actual mortgage rate. The latter part is the number of discount points that you are required to pay at the time you close on your loan. These points are a type of prepaid interest or fees.
What are mortgage discount points?
Mortgage discount points are a one-time closing cost that comes hand in hand with your home loan. You pay the points in order to secure the mortgage rate. Discount points are considered “prepaid mortgage interest.” As a result, they are tax-deductible (please consult your tax preparer to confirm).
One point is equal to 1% of the amount that you’re borrowing. For instance, on a $100,000 loan, each point would cost $1,000. In general, each point that you pay will lower your mortgage rate by 0.25%.
It is important to note that discount points are different from origination points. Both are points that affect the interest rate of a mortgage and are both used during closing. However, these points, which are essentially fees, serve different purposes.
How do these points affect my mortgage rate and payments?
For each point you are charged, the lower your mortgage rate is. Essentially, these discount points buy-down your interest rate in the form of fees. The lender receives a lump sum when you close on your loan, rather than when you make your interest payments every month.
A mortgage with high points is beneficial if you have the cash to pay for the points. You’ll end up paying less month after month for the duration of your loan term. However, if you can’t afford to purchase as many points, you can choose a loan with fewer discount points. Unfortunately, this will result in a higher interest rate.
It is important to note that there is a “break-even point.” Purchasing points is only advantageous if you intend to keep the mortgage past this “break-even point.” This cut off varies with your loan size, interest rate, and term. If you sell your home or refinance before the “break-even point,” you will lose the money on what you paid for the discount points.
Here’s an example.
You take out a $200,000 mortgage. If you did not purchase any discount points, you would pay the maximum 5% interest for the loan term. As a result, the payment works out to $1,073.64 per month.
On the same $200,000 mortgage, you purchased 1 point. 1% of $200,000 is $2,000. This discount point cost you $2,000. Your 5% interest rate is then lowered to 4.75%. As a result, your monthly payment is lowered to $1,043.29. That is a monthly savings of $30.35.
The break-even point is 66 months. By purchasing the discount point, you pre-paid the interest on your home loan. You spent $2,000. However, you would make it back in monthly savings after 66 months. Therefore, from that point on, you would now be saving $30.35 every month.
Once you have an idea of how long you intend to live in your home, you can calculate when you will break even and how many discount points you can afford to buy.