What are discount points?

Mortgage 101
Although buying a home typically requires a sizable down payment, discount points can help to reduce the cost of a mortgage.
Published on
March 28, 2023
Copy link

Choosing to purchase a home is among the most important financial decisions you'll ever make. Because of how much it costs to buy a home in any market, it's important that you weigh all your options before taking this route. While buying a home typically requires a sizable down payment, there are several things you can do to reduce the cost of a mortgage. Along with searching for the lowest interest rates available to you, it's also highly recommended that you consider obtaining discount points to reduce the total amount of interest that you need to pay.

What Are Discount Points?

Discount points are a kind of prepaid interest fee that you can buy when you want to reduce the interest that you pay on future monthly mortgage payments. You will essentially be paying more upfront in order to pay less later on. Another benefit of purchasing discount points is that you can deduct them from your taxes.

How Do Discount Points Work?

Every discount point you purchase reduces your total interest rate by around 0.25%. If your current interest rate is 3.75%, buying one discount point may allow you to reduce your rate to 3.50%. The exact amount that a discount point reduces your interest rate by depends on the lender that you're borrowing from. The type of mortgage you're applying for can also dictate how much your interest rate is reduced by.

Keep in mind that one discount point costs 1% of the total mortgage value. If you are obtaining a mortgage loan that's valued at $250,000, one discount point would cost you $2,500. If you have enough savings, it's possible to purchase multiple points to reduce your interest rate by even more. You could also purchase fractions of a single point. If you want to purchase half of a point, doing so on a $250,000 mortgage would cost $1,250.

You'll find that there isn't a strict limit on the number of discount points that you can purchase. However, most lenders don't allow prospective homeowners to purchase more than four of these points, which means that you would be able to reduce your interest rate by around 1% if you buy the maximum points.

When you purchase one or more of these points, you'll be asked to pay for them at closing. They will be listed within your loan estimate document as well as the closing disclosure document. Before you decide to purchase discount points, it's important to understand that you aren't required to buy these points with your own money. It's possible for the cost of these points to be rolled directly into your loan balance or to be paid by the seller as a result of negotiations.

What to Consider When Deciding if Discount Points are Worth It

When you're trying to decide if discount points are right for you, there are several things that you should take into consideration. Even though discount points provide you with the opportunity to reduce your interest rate as well as your monthly mortgage payments, the upfront costs can be high. If you're on a strict budget for your home, you may be unable to afford discount points in the event that your down payment is high.

When this occurs, you need to take some time to consider which option is preferable. A higher down payment will invariably reduce your interest rate and potentially keep you from having to pay for private mortgage insurance. On the other hand, buying discount points is a great way to lessen your interest rate while also being able to deduct the money you spend from your taxes.

When looking specifically at the tax benefits that come with buying discount points, nearly everyone who purchases discount points will have the ability to deduct these points from their next tax returns. The IRS allows new homeowners to deduct all of the points they purchase in the year that they purchase them. If you purchase four points at $2,500 per point, you could deduct $10,000 from your annual tax return. Keep in mind, however, that you may be limited on the number of points that you can deduct if you purchase a home that costs more than $750,000.

If you find that you're unable to deduct your discount points in the year that you purchase them, it's still possible to deduct them on your taxes over the life of your mortgage loan. Claiming a discount point deduction is simple and straightforward. These points can be claimed as an itemized deduction on Schedule A, which is part of Form 1040. It's important to understand that these tax benefits are only available for individuals who use itemized deductions on their tax returns.

How to Determine the Break-even Point

Discount points can be beneficial if you plan on living in your home for many years before placing it on the market. However, it's possible to calculate the break-even point, which refers to the point in time when you will recover what you paid for your discount points. To calculate the break-even point, you will be tasked with dividing the total cost of your mortgage points by how much you save every month as a result of the reduced interest rate.

Let's say that you purchase two discount points at a cost of $2,000 per point. As such, your upfront costs will amount to $4,000. If your monthly mortgage payment is reduced by $56, it would take around 71 months for you to reach the break-even point, which is just under six years. After this point, your monthly savings will essentially be pure "profit".

It's also important to note that the amount of money you spend on discount points can be deducted from your taxes if you happen to itemize, which further increases your savings and could allow you to reach your breakeven point sooner than anticipated. Because the breakeven point takes numerous years to reach, it's highly recommended that you only purchase multiple discount points if you believe that you will live in your home for many years. There are plenty of online calculators you can use when attempting to determine what your breakeven point will be.

How Mortgage Origination Points Differ From Discount Points

When you're getting ready to apply for a mortgage, you'll be able to pay for discount points and origination points. While both types of points are considered to be mortgage points, they are meant to be used in different situations. Mortgage origination points are points that you will need to purchase when you want to pay lenders to originate and process your loan. Every borrower must purchase mortgage origination points if they want to obtain a mortgage.

While everyone is required to pay for origination points when applying for a mortgage, these points are considered to be part of your closing costs. Just like a discount point, origination points cost around one percent of your total mortgage amount. Let's say that your lender charges 1.5 points on a $300,000 mortgage. At this rate, you would pay $4,500 in origination fees.

It's possible to receive a mortgage without paying for mortgage origination points. However, you will then need to pay for other fees or a higher interest rate in order to compensate. Keep in mind that buying discount points won't reduce the amount you'll be required to pay for origination fees.

Are Discount Points Worth It?

Now that you have a better understanding of what discount points are, you might be wondering if they're worth the money. The answer to this question depends on your situation and the amount of money you currently have in your savings. Purchasing discount points at the beginning of your loan allows you to lessen the overall costs of obtaining a loan. While these savings aren't immediately noticeable, they can add up over time and will eventually become higher than your initial costs if you own your home for long enough.

Even though the long-term savings that occur from buying discount points can be high, a substantial percentage of borrowers find that buying discount points at the start of their loan is too much of a financial burden at a time when expenses are already high. If you're already paying for moving costs and a high down payment, it's possible that you simply don't have enough money in your savings to pay for discount points.

As mentioned previously, there are steps you can take to buy discount points without being required to pay for these points out of your own pocket. During negotiations with the seller, you could ask them to pay for your discount points instead of asking them to pay for repairs or reduce the asking price. You might also want to think about rolling the cost of these points into your mortgage, which means that you would pay for them over a lengthy period of time.

You might also benefit from making a higher down payment instead of buying discount points. A down payment of 20% or more will allow you to avoid private mortgage insurance. Your interest rate will also be lowered from paying more on your down payment, which could outweigh the benefits provided by discount points. Before you make your final decision, take all of these factors into consideration.

Want to speak with an expert?
If you have questions about home financing or you'd like to see what options are available, connect with one of our experts today!
Connect with an expert
Latest posts

Don't Stop Here

Check out some of these related articles.
A hand holding a small picture of a home.

The Difference Between Non-QM and Qualified Loans

Your mortgage does not have to be complicated! If you are interested in non-QM or qualified mortgages, we can help you understand the different options available to you.
Read post

Types of Mortgages

It is important to know of the numerous mortgage types that you can select from, that way when the time comes you can choose what is best for you.
Read post

What is a mortgage note?

A legal document which outlines the terms of a loan between the buyer and lender
Read post