Mortgage discount points are an optional fee that some borrowers choose to pay their lender in exchange for a lower interest rate on their mortgage loan.
As a general rule, paying for points may be a good idea if you plan to keep your mortgage for years. If you plan to sell or refinance within a short period of time, paying for points may not make sense.
What are the discount points on a mortgage?
The term “point” refers to the down payment based on a percentage of the loan amount. One point equals 1%, so for a loan amount of $400,000, one point equals $4,000.
Points can be fractional amounts, such as an eighth, a quarter or half of a 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 equal in all other respects and from 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 at every lender or for every type of loan. . However, the amount of the discount may vary depending on other lender-specific factors and mortgage market trends.
How to decide
It is not always easy to determine if paying for discount points is reasonable. 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 will help you determine when your total savings will equal your initial costs.
As a general rule, paying off points will be more attractive if you plan to keep your home and your mortgage for at least a few years after you recoup your initial cost.
A breakeven analysis is generally more useful if your loan has a fixed rate 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 method is not a valid comparison.
Tip 2: Think about your money position
You can pay the discount points up front in cash, along with your . But if you’re on a tight budget or you’re planning to do a lot of renovations or improvements to your home right away, you may not want to pay for discount points up front.
Two other options are to spend the discount points as part of your loan amount, which can increase your payment or interest costs, or negotiate for the seller of the home you want to buy to pay off the points in discount for you.
Tip 3: Consider your income tax situation
Mortgage discount points can be tax deductible if you itemize your deductions when you file your federal income tax returns. This tax deduction helps you pay less tax. Your tax savings will be a factor in your breakeven analysis.
Tip 4: Re-evaluate your desired loan amount
Paying for points may help you qualify for a larger loan amount because your monthly payments are usually cheaper with a lower rate than with a higher rate. If your income isn’t high enough for you to qualify for the loan amount you want, paying for points can be a solution.
Discount points or temporary purchases?
A temporary buydown that lowers your rate for a few years after you buy your home is not the same as paying points to get a lower rate for the entire term of your loan.
A temporary purchase may save you money for a few years, but once the introductory rate expires, your payments will be higher. This is known as a “rate shock.” You may be able to do it at a lower rate, but that’s not guaranteed.
“Should I pay for discount points” is a complicated question because you have to consider your upfront spending, future spending, breakeven points, and more. Do your best to think about your plans for the future and run the numbers to make sure you’re comfortable with your monthly payments before you decide to pay points — or not.