Should I Pay Mortgage Discount Points for a Lower Interest Rate?

Should you pay discount points to get a lower interest rate on your mortgage? That’s the question we will address in this tutorial. By the time you finish reading this article, you will understand (A) what discount points are, (B) how they can be used to reduce interest costs, and (C) when it makes sense to pay them.

Let’s start with a brief definition of mortgage discount points, for those who are unfamiliar with the concept.

Definition of Mortgage Discount Points

Definition: A discount point is a form of prepaid interest that can be used as a money-saving strategy by mortgage borrowers. The idea is to pay a little more at closing in order to secure a lower interest rate, thereby saving money over the term of the loan.

One discount point equals 1% of the mortgage amount. So a single point would equal $3,000 on a $300,000 loan; $4,000 on a $400,000 loan; and so on. If you multiply the loan amount by .01 (the decimal form of 1%), you will get the value of one point.

On Average, One Point Will Lower the Rate by 0.25%

So, you can pay discount points at closing to get a lower rate on your mortgage. We’ve covered that. But how much do lenders reduce the interest rate for each point that is paid up front? This will vary slightly from one lender to the next.

Generally speaking, the rate will be lowered by one fourth of a percentage (0.25%) for every discount point the borrower pays. This is just a rule of thumb. Your lender should present you with various options using real numbers, if you decide to use this strategy.

It’s important to note that paying discount points at closing will not lower your loan amount. This is a common misconception, especially among first-time home buyers who are new to the concept.

The ‘Break-Even’ Shows When You Start to Benefit

Should you pay points at closing to get a lower rate? To answer this question, you must determine the break-even point. This is when the money you have saved (by paying a lower interest rate) begins to surpass the extra amount you paid up front (in the form of discount points).

Once you know the exact amount of the rate reduction, you can calculate your break-even point. This is the most logical way to determine whether or not you should pay discount points for a lower mortgage rate. It tells you when you will start to see benefits, in the form of accumulated savings over the long term.

To calculate your break-even point, you can divide the amount charged for points by the amount you would save each month.

Let’s say you pay $1,000 in discount points to secure a lower interest rate on your mortgage. This will reduce your monthly payments by around $15 per month. In this scenario, you could divide 1,000 by 15 to reach 66.6. That is the number of months it would take to reach the break-even point, after which your savings will begin to surpass the additional upfront expense. It will take 66.6 months, or about 5 1/2 years. If you were only planning to keep the loan for three or four years, paying points would not work to your advantage in this example.

As a general rule, borrowers tend to reach the break-even point sometime around the fifth year of holding the loan. That means borrowers who plan to sell or refinance before five years may not benefit from this strategy. On the other hand, borrowers who plan to stay with the same loan for more than five years could benefit from paying discount points for a lower rate.

When considering this strategy, you must also consider your long-term housing plans:

• Short term. If you think you’ll be selling the house or refinancing within two or three years, it probably doesn’t make sense to use discount points to reduce your rate. In this short-term scenario, you probably won’t keep the loan long enough to see any financial benefits from the strategy. In other words, the extra amount paid at closing will exceed the amount you save in the form of a lower interest rate. Experts agree that paying discount points for a lower interest rate is a long-term strategy for saving money.
• Long term. A borrower who keeps the same mortgage for, say, six years or more will likely save money by using points. In this scenario, the borrower is paying a lower interest rate over a longer period of time, thereby accumulating more savings. At some point, the money saved will begin to exceed the amount paid at closing in the form of discount points. The long-term borrower will eventually reach, and move beyond, the break-even stage mentioned earlier.

If you are considering this strategy, ask your mortgage lender to prepare a chart or spreadsheet that shows all of your options. The lender should be able to calculate the break-even for different scenarios, based on the amount of discount points paid at closing. This will help you make an informed decision.

Conclusion & Recap

This article answers the question: Should I pay discount points for a lower interest rate on my mortgage? We have attempted to answer this question as thoroughly as possible, accounting for different types of lending scenarios. But your scenario may be different from those presented above. You may encounter unique circumstances that make these general rules less applicable. That’s why you should have your lender present some options.

Specifically, the lender should explain: (A) the amount of discount points you can pay at closing, (B) the degree to which you will reduce your interest rate and monthly payments, and (C) the number of years and months it will take to reach your break-even. Those are the three most important factors when deciding whether or not to pay discount points for a lower mortgage rate.