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What are mortgage discount points and should you pay for them?

Yahoo Personal Finance· Getty Images
Updated 4 min read

Mortgage discount points are an optional fee you can pay to lower the interest rate on a home loan.

Discount points can be a strategic financial tool for a borrower — or a misleading junk fee used by a lender.

Read more: 13 steps to buying a house

Sometimes lenders add discount points to an advertised rate to lower it and make an interest rate more attractive. If you want that rate, you'll need to pay the required points to get it.

However, it's your choice.

A better way to shop mortgage rates from one lender to the next is to ask them to make a loan offer based on zero discount points. Now you've stripped out the rate sweeteners and are being quoted rates you can truly compare head-to-head.

Read more: Freedom Mortgage review

It's not always easy to determine whether buying discount points makes sense. These four tips may help you decide.

A breakeven analysis compares the cost of your discount points to the monthly savings from your lower rate.

As a general rule, paying for points may be more attractive if you're planning to keep your home and your mortgage for at least a few years. That way, there's time to recoup your upfront cost.

Let's look at an example.

A discount point often lowers your interest rate by about 0.25%. On a $350,000 loan and a 6.5% interest rate, with one discount point costing $3,500, the rate would be reduced to 6.25%.

Your payment would be reduced from $2,212 to $2,155, a monthly savings of $57.

$3,500 (cost of one point) divided by $57 (monthly savings) = 61.40 months

So, your breakeven time would be just over five years.

Don't try to compare a breakeven analysis with a fixed rate to a breakeven analysis with an adjustable rate. Besides the fact that your brain might explode from layers of complexity, it really isn't a valid comparison. A variable rate will change — and you can't predict by how much or if it will be higher or lower.

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 pay for a lot of repairs or improvements to your home right away, you may not want to buy discount points upfront.

Another option is to finance discount points as part of your mortgage, which may increase your payment or interest expense. So you're adding the cost of your discount points to your loan debt, which you will then pay interest on for the entire loan term. In that case, you're paying more interest to reduce interest. Even AI may not be able to calculate that.

You can also try to negotiate for the seller of the home to pay for discount points for you. Your success in bargaining for such a concession will depend on how competitive your local real estate market is — and how badly the current owner wants to sell the house.

Mortgage discount points may be tax-deductible if you itemize your deductions when you file your federal income tax returns. A deduction helps you pay less in taxes. Your tax savings could be a factor in your breakeven analysis.

Paying for points may help you qualify for a larger loan amount because your monthly payment typically will be cheaper with a lower rate than it would be with a higher rate. If your income isn't high enough for you to qualify for the loan amount you want, paying points may be a solution.

But don't game yourself into being house poor. Paying to get a lower rate on a higher loan balance might not be your best wealth-building plan.

Read more: How much house can I afford?

A temporary mortgage rate buydown lowers your rate for a few years. That's different from paying for points to obtain a lower rate for the full term of your loan.

A temporary buydown may save you money for a few years, but once the introductory rate expires, your payment will likely be significantly higher. This is known as "rate shock." Not a good thing. You might be able to refinance your mortgage at a lower rate, but that's a risk

“Should I buy discount points” is a question that requires thinking about your upfront and future costs, breakeven time, and more.

Consider 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.