Most lenders offer borrowers the option to pay discount points to obtain a lower mortgage rate than they would otherwise receive. A discount point is a one-time, upfront fee that equals 1% of the mortgage amount. For example, if your mortgage amount is $300,000, one discount point would cost the borrower $3,000. If you pay a half discount point in this example, it would cost $1,500.
You usually pay for discount points out-of-pocket as an extra closing cost although you may be able to add the point cost to your loan with a financed permanent buy down. Instead of paying for the points at closing with your own funds, with a financed permanent buy down you add the cost to your mortgage which increases your monthly payment slightly and means you pay interest on that additional cost as well. Because the main reason to pay discount points is to reduce your monthly payment, most people choose to pay for them up-front.
A discount point should not be confused with an origination point, which is a fee that some lenders charge to process and close your mortgage. Origination points are mandatory if the lender requires them whereas discount points are totally optional for borrowers. To reiterate, it is completely up to you to decide if you want to pay discount points to reduce our mortgage rate and lenders cannot force or require you to pay them.
In short, if you decide to pay discount points then your mortgage rate should be lower than if you do not pay points, so there is a trade-off. But how do you compare the cost of a discount point, an up-front fee equal to 1% of the mortgage amount, to the benefit of a lower mortgage rate, the ongoing cost of your loan? As a rule of thumb, one discount point is equivalent to .250% (1/4 of 1%) in mortgage rate and a half of a discount point is equivalent to .125% (1/8th of 1%) in rate.
For example, if you receive a mortgage quote with a 4.000% interest rate plus one discount point, this equates to a mortgage proposal with a 4.250% interest rate with zero discount points. If you receive a proposal for a loan with a 4.250% rate plus a half discount point, this is equivalent to a loan with 4.375% mortgage rate and no discount points. You can use this guideline, in addition to other factors including how long you intend to own the home and have the mortgage, to determine if it makes financial sense for you to pay discount points.
Your mortgage rate affects both your monthly payment as well as the total interest you pay over the life of the loan. The longer you have your mortgage, the more you benefit from the lower monthly payment and reduced total interest expense that results from paying discount points to lower your rate. You should consider both the short and long term financial impact to make sure that the benefits exceed the discount point cost.
The example below shows the financial impact of paying discount points. The example compares a scenario where the borrower pays one discount point to a scenario where the borrower does not pay any discount points. The example looks at a $300,000 30 year fixed rate loan and shows the difference in discount point cost, mortgage rate, monthly payment and total interest expense over the life of the mortgage for the two scenarios. The example also shows how long it takes to recover the discount point cost.
In the scenario where the borrower pays one discount point, the borrower pays an extra $3,000 upfront, but reduces their mortgage rate from 4.250% to 4.000%. The borrower saves $44 per month on their mortgage payment and $15,685 in total interest expense over the life of the loan. This example shows the benefits of paying discount points in terms of lowering your monthly payment and total interest expense in the long run, especially if you keep your mortgage for the entire 30 year term.
It is also important to understand how long it takes you to recover the cost of paying for discount points. In the example below, if you divide the upfront discount point cost of $3,000 by $44 per month in savings, it takes more than 68 months, or more than five and a half years, to recover the cost of the discount point.
This highlights an important rule of thumb when you are considering paying points: if you are planning on owning the property being financed for more than five years and if paying a discount point reduces your mortgage rate by at least .250%, then paying discount points usually makes financial sense. If you are planning on having the mortgage for less than five and a half years then you may not be able to fully recover the cost of the discount point but you still benefit from the lower monthly payment.
If you plan on owning the property you are financing for less than five years it typically does NOT make sense to pay discount points because you cannot recover the cost in that time period
The graphs below show how the mortgage rate decreases as the number of discount points increases. As illustrated by the graphs, a half of a point should reduce the interest rate by .125% (1/8th of 1%) and one point should lower the rate by .250% (1/4 of 1%). You can use these charts to determine what your mortgage rate should be depending on the number of discount points you pay. The more points you pay, the lower your rate should be but make sure the reduction in your rate and monthly payment is large enough to justify the cost.