Mortgage discount points are an optional fee that some borrowers choose to pay to their lender in exchange for a lower interest rate for their mortgage loan.
As a general rule, paying points might be a smart idea if you plan to keep your mortgage for many years. If you plan to sell or refinance within a short timeframe, paying points may not make sense.
Read more: First-time home buyers’ guide
What are discount points on a mortgage?
The term “points” refers to an upfront fee that’s based on a percentage of the loan amount. One point equals 1% of the loan amount, so for a $400,000 mortgage, one point would cost $4,000. Some lenders allow fractional points, such as one-eighth, one-quarter, or one-half of one point.
However, the rate reduction is not one-to-one. One discount point typically lowers your interest rate by 0.25%. That means paying $4,000 for one discount point on a 7% mortgage would lower the rate to 6.75%.
Not every discount point program is the same. A lender’s cost-to-reduction ratio can vary based on the market and their own pricing strategy. So try to compare several lenders before you commit.
How to decide
It’s not always easy to determine whether paying discount points makes sense. 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 can help you figure out when your total savings will equal your upfront cost.
To calculate your breakeven, divide the total cost of your discount points by your monthly savings. The resulting number is how many months it’ll take you to recoup the costs.
As a general rule, paying points may be more attractive if you’re planning to keep your home and your mortgage for at least a few years after you recoup your upfront cost.
For example, one discount point on a fixed 30-year $400,000 mortgage at a 7% interest rate lowers your rate to 6.75% and costs $400,000. This saves about $67 per month, which means you’re breaking even in roughly 60 months or about five years.
Selling the home or refinancing before you break even means you’ve paid for discount points, but you didn’t realize all the savings.
Read more: How to calculate your break-even point on a mortgage refinance
Tip 2: Consider your cash position
You can pay for discount points upfront in cash, along with your closing costs. But if your cash is limited or you’re planning to make a lot of repairs or improvements to your home right away, you may not want to pay discount points upfront.
Two other options are to finance discount points as part of your loan amount, which may increase your payment or interest expense, or negotiate for the seller of the home you want to buy to pay discount points for you.
Tip 3: Consider your income tax situation
Mortgage discount points may be tax-deductible. The IRS treats points like prepaid mortgage interest, so claiming them can lower your taxable income for the tax year in which you paid them. However, you must meet IRS requirements.
To start, you’ll have to itemize your tax return to claim the deduction. The points must be for a loan used to buy or significantly improve your primary residence. Discount points on refinanced mortgages are handled differently.
There are several additional IRS rules, and they can be complex. It’s worth discussing your specific situation with a tax professional.
Read more: How much house can I afford?
Seller-paid discount points
Sometimes sellers are willing to buy mortgage points on the buyer’s behalf. It’s one of many seller concessions buyers can ask for, especially in cooling housing markets where there are more homes than there is demand.
With the seller buying down the interest rate, you get the full benefit of a rate reduction without much of the downside.
And in a high-interest-rate environment, the monthly savings from a seller rate buydown could be more substantial than asking for a lower purchase price.
Discount points or temporary buydown?
Discount points are a permanent rate buydown. However, there’s also a temporary buydown option.
With a temporary buydown, you or the seller pays the upfront cost for a short-term rate reduction, usually lasting one to three years. It’s often a strategy buyers choose if they plan to sell or refinance before the temporary buydown period ends.
Temporary buydowns typically have the lowest rate in the first year, with increases each year thereafter, depending on the structure.
For example, a 2-1 buydown reduces the interest rate by 2% in year one. It then increases by 1% in year two and returns to the original rate in year three.
“Should I pay discount points?” is a complicated question since you have to consider your upfront spending, future costs, breakeven points, and more. Do your best to think about your plans for the future and run the numbers to make sure you feel comfortable with your monthly payment before you decide to pay points—or not.
Mortgage Discount Points: FAQs
Are discount points worth it?
Generally, discount points are worth it if you plan to keep the same mortgage past your breakeven point—the number of months it takes for your savings to exceed what you paid for the points. But it’s also important to consider if that money is better suited for a larger down payment, emergency savings, or another financial goal.
Are discount points tax-deductible?
Discount points can be tax-deductible in the tax year you purchased the points if you itemize deductions, used the mortgage to buy or improve your primary residence, and meet several other IRS requirements. Consider talking with a tax professional to understand the tax implications for your situation.
How much does one discount point lower your rate?
One discount point generally lowers your interest rate by 0.25%. However, this can vary by lender and fluctuate with market conditions. Be sure you compare lender discount programs before you make your decision.
Can the seller pay discount points?
Yes, sellers can purchase discount points for buyers. It’s known as a seller concession, which is a common negotiation tactic as the housing market shifts from a seller’s market to a buyer’s market.