Discount points in mortgage are used to reduce interest rate. You purchase these points directly from your lender and you pay them at closing. Many lenders don’t incorporate points when they advertise their interest rates, but there are lenders that quote lower rates together with points. A home loan priced at 5 percent is not always costlier than a loan advertised at 4.75 percent with 2 points.
The dollar value of one discount point is equivalent to one percent of your loan amount. For example, if your loan amount is $200,000, one point is equal to $2,000. If you buy one point, you pay $2,000 at closing, and if you buy three points, you pay $6,000 at closing.
The equivalent rate reduction varies from bank to bank and from loan program to another. If, for instance, the bank rate reduction per point for your loan program is 0.25 percent, your rate drops by 0.25 percent for every point you purchase.
Comparing Points and Down Payment
A legitimate question would be why you don’t just increase your down payment rather than buy points. The answer would be: The two actions have different direct effects, although they have the same ultimate goals – to lighten monthly payments. Points would reduce your mortgage rate while a bigger down payment would reduce significantly your loan amount. You can estimate the effects of both down payment and points on monthly payments and on the entire loan, and then choose what suits your home ownership plans.
If you plan to stay in your home for a longer time, buying points would be beneficial. For example, if you buy three discount points with $6,000 in order to lessen your mortgage rate and in turn reduce your monthly payment by $275, you’d earn back what you invested in points after one year and 10 months. That’s $6,000 divided by $275, which equals 21.8 months. If you plan to continue owning your home and paying your monthly for a total of five years, you’d save a total of $10,500. And if you intend to pay the entire loan in 30 years, you’d save a total of $93,000.
Additionally, buying points can also reduce your income tax, as paying points is considered by the IRS as paying mortgage interest in advance.
On the other hand, making the 20-percent down payment – the required down payment level for many home loans without private mortgage insurance – will save you from buying a PMI. Naturally, the ideal would be a situation where you’re able to both pay the 20-percent down payment and buy some points.
If you need to choose between buying discount points and making the 20-percent down payment or a bigger down payment, consider buying points only if:
- Your mortgage is a fixed-rate type, and not a variable- or adjustable-rate type wherein points apply only to the fixed-rate portion of an adjustable-rate loan.
- You’ll stay in your home for a longer time than your break-even period.
- You can also pay your required down payment.
With your knowledge of discount points, you and your lender can arrive at a mortgage deal that results in lower monthly payments and in substantial savings.