12. What Are Discount Points?

by Local Title

Discount points, also known simply as points, are a form of prepaid interest that homebuyers can pay upfront to lower the interest rate on their mortgage. Each point is equivalent to 1% of the total loan amount and can significantly reduce the overall cost of the loan over its term.

How Discount Points Work

When you take out a mortgage, you have the option to purchase discount points to reduce your interest rate. For example, if you have a $200,000 loan, one point would cost $2,000. In exchange for paying this upfront fee, the lender reduces your interest rate, often by 0.25% per point. The exact reduction can vary depending on the lender and market conditions.

Benefits of Buying Discount Points

Lower Monthly Payments

The primary benefit of purchasing discount points is the reduction in the monthly mortgage payment. By securing a lower interest rate, you pay less in interest over the life of the loan. This can make your monthly payments more affordable and free up cash flow for other expenses.

Long-Term Savings

Although buying discount points requires an upfront payment, the long-term savings can be substantial. Lowering the interest rate means you will pay less in interest over the entire term of the loan. This can result in significant savings, especially on a long-term mortgage such as a 30-year loan.

Tax Deductibility

In many cases, the cost of discount points is tax-deductible. The Internal Revenue Service (IRS) allows homeowners to deduct the cost of points in the year they are paid if the mortgage is for a primary residence. This can provide additional financial benefits by reducing your taxable income.

Considerations Before Buying Points

Break-Even Point

Before deciding to buy discount points, it’s essential to calculate the break-even point, which is the time it takes for the savings from the reduced interest rate to exceed the cost of the points. If you plan to stay in your home for a long time, buying points can be a wise investment. However, if you expect to sell or refinance the home within a few years, the upfront cost may not be worthwhile.

Available Funds

Purchasing discount points requires an upfront payment, which adds to the initial costs of buying a home. It’s crucial to ensure you have sufficient funds to cover these costs without depleting your savings or emergency fund.

Discount points can be an effective way to lower your mortgage interest rate and save money over the life of the loan. However, it’s essential to carefully consider your financial situation, how long you plan to stay in the home, and whether the upfront cost fits into your budget.