I think it goes without saying that everyone with a mortgage (or thinking about getting one) wants the lowest rate possible. After all, who wouldn’t want to save money each month for the next 30 years or so of their life?
That brings us to “mortgage discount points,” which are paid by borrowers at closing to reduce the mortgage rate on a home loan.
Put simply, borrowers pay a percentage of the loan amount, known as a mortgage point (or some fraction of one), to lower the interest rate by a certain amount, though it’s never perfectly proportional.
They are considered a form of prepaid interest, as the upfront cost lowers the interest rate you would normally be stuck with during the loan duration. The good news is that means they’re also tax deductible.
Let’s look at an example of mortgage discount points in action:
Loan program: 30-year fixed
Loan amount: $200,000
Par rate: 5.00%
Desired rate: 4.50%
We will assume you qualified for an interest rate of 5.00% with no costs, aside from a loan origination fee of 1%. But say you want to snag a lower mortgage rate, say 4.50%. In order to do so, you’ll need to come up with more money at closing in the way of mortgage discount points.
So the mortgage broker or bank may say you need to pay two discount points to lower your interest rate by a half of a percentage point.
In our example, that would mean a total cost of $4,000 ($2000 x 2) in mortgage discount points to obtain the desired mortgage rate. So instead of making higher mortgage payments each month, you’d pay more at closing. That’s the tradeoff.
This favors the mortgage lender because they get more money upfront, and you, assuming you stick with the loan long-term.
Does it make sense to lower my rate using mortgage discount points?
Before actually paying mortgage discount points, you need to be sure it actually makes sense to buy down your interest rate – the answer to this question will vary greatly depending on what mortgage rate you are initially offered, how much it will cost to buy down the rate, and how long you plan to stay with the mortgage/in the home.
As a rule of thumb, mortgage discounts points make more sense for those who plan to stick with their mortgage for the long-haul, as the interest saved over the years can be exponential. On the other hand, if you plan to move or refinance again in the near future, paying mortgage discount points could be a complete waste of money.
Also be sure to consider your asset situation. If you don’t have a lot of money saved up, you won’t want to blow what little you do have lowering your mortgage rate by some incidental amount.
As I mentioned earlier, mortgage discount points aren’t a perfect science, meaning it could cost three points to lower your interest rate one percent, or just two points to lower it three-quarters of a percentage point.
Tip: Don’t focus on a certain interest rate, as the cost may not justify the discount. For example, if you have your eye on a 4% mortgage rate, don’t just pay for it so you can tell your friends about your low rate. If the cost isn’t justified, look at other options. It may cost half that price to go with a rate of 4.25% instead.