What Are Discount Points on a Mortgage?

When pricing mortgages, most lenders offer borrower discount points, which are a form of prepaid interest on home loans. When a home buyer chooses to purchase discount points, he will benefit from a lower interest rate and monthly mortgage payment over the entire life of the loan. Since buying points is an important decision – after all, it affects a borrower’s pocketbook month after month, over the length of the loan – we’ve decided to use this post to explain what discount points really are and how a home buyer can make the most of them.

Understanding the Basics

The first thing a home buyer should know is that 1 discount point equals 1 percent of the total mortgage amount and reduces the interest rate by 0.125 to 0.25 percent. When a borrower buys discount points at the closing, he makes a trade-off between upfront costs and monthly mortgage payments. This means that the more points he buys at the closing, the less he will pay over the life of the loan, which will translate into hefty savings.

For example, a borrower who takes out a 30-year $150,000 mortgage with a 5 percent interest rate will have to pay $805.23 per month, which means a total of $289,883 after 30 years ($139,883.68 interest). If he buys 2 points to secure an interest rate of 4.5%, the monthly mortgage payment will be $760.03, saving him $45.20 a month. In 30 years, the borrower will pay $273,610.07 ($123,610.07 interest) and save $13,273.61, after subtracting the $3,000 cash advance for the 2 points. If the borrower buys 4 points, he will save $26,079.42 in total.

Although 0.25 percent is the typical interest rate reduction a home buyer may receive when buying 1 discount point, it mainly depends on the loan terms. If 1 point reduces the interest rate by 0.125 percent, the borrower needs to purchase 8 points to reduce the interest rate by 1 percentage point.

Assessing the Benefits

A lower interest rate will allow borrowers to pay down mortgage balances faster and build equity in their homes sooner than estimated by their mortgage amortization schedules. Another aspect overlooked by many home buyers is that discount points are tax deductible, but only when certain criteria are met.

According to specialists, buying points makes more sense if the home buyer plans to stay in the house for a long time. However, purchasing points may be advantageous for anyone who meets the requirements for deducting points in the year paid. That’s because deducting points in full in the year they’re paid will allow the borrower to recoup the investment when he files his tax return. Plus, the home buyer can deduct the cost of the points even if he didn’t pay for them.

Avoiding the Problems Relating to Discount Points

Some loan officers engage in the practice of charging discount points that don’t result in an interest rate reduction. These points are called “unearned” points and reflect violations of the Federal Trade Commission Act against unfair or deceptive practices.

To get the very most out of discount points, it’s imperative to find a reputable lending company that has plenty of positive customer reviews and displays relevant logos on its website, which prove that it’s a member of prestigious organizations, such as Mortgage Bankers Association and National Association of Mortgage Brokers, and has enrolled into specific programs like BBBOnLine Reliability Seal Program and Equal Housing Opportunity. A lending institution that meets these conditions always complies with applicable federal, state and local regulations.

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