Discount points, also known as mortgage points, are the amount the borrower pays to the lender to reduce the interest rate on their loan.
If you’re interested in real estate, you must understand how mortgage points work, as they are a crucial aspect of the real estate industry. As a real estate educator, lately, I’ve noticed many students struggling to understand discount points and their real life application.
In this post, I’ll define discount points and provide some examples. After reading this post, you’ll be able to understand the significance of discount points and more!
What Are Discount Points
Discount points are prepaid interest that the borrowers can buy to reduce their interest on the monthly payment. These points are in the form of an upfront payment or a one-time fee that is included in the closing cost.
Discount points are equal to a certain percentage of the loan amount. One point is equal to 1% of the loan amount. For instance, on a $300,000 loan, 1 discount point will equal $3000, that is, 1% of the loan amount. Thus, one discount point lowers the interest rate by 1%. So, if the interest rate on this loan is 4.5%, the interest rate will decrease by 0.25%.
Discount points are a good option if the borrower intends to keep the loan for a long time. If the borrower pays more upfront in the form of discount points, they’ll be able to spend less in the future. Purchasing discount points can result in significant savings in the future. The borrower can buy discount points as many as they want and are also open to negotiation.
Break Even Point
A break-even point helps determine whether purchasing discount points is a good option. Besides that, the borrower must also consider whether they plan to live in the home for a long time. Lenders can also help decide whether purchasing points are beneficial or not. You can calculate the break-even point as follows:
- Cost of 2 mortgage points: $4000
- Monthly savings: $58.54
- Break-even point: $4000/$58.54 = 68
It requires 68 months to reach the break-even point. In this case, purchasing mortgage points is beneficial if the homeowner plans to live in the home for more than 68 months. On the other hand, mortgage points are not useful if the homebuyer, in this case, plans to live in the home for less than 68 months.
How Do Discount Points Work?
Borrowers can pay discount points in the form of an upfront cost. Buying mortgage points helps them gain a long-term reduction in interest rates. When the borrower pays for discount points, they have paid an amount to lower the interest rate. This is called a buy-down. Discount points equal 1% of the mortgage balance, not the original mortgage. This means that when the borrower makes a down payment, the amount that remains is the mortgage balance.
For example, a person purchases a home for $400,000 and puts down 20% as a down payment. The discount point will not equal 1% of $400,000 but the amount obtained after subtracting the down payment.
In this case, the down payment is $80,000, and the mortgage balance is $320,000. The cost of 1 discount point is 1% of $320,000, which is $3200. For mortgage lenders, discount points help them yield more upfront cash on the loan. For borrowers, discount points help them buy down the interest rate.
Discount vs. Origination Points
Origination points are the cost incurred on the processing, evaluation, and approval of loans. One origination point is equal to 1% of the loan amount. Discount points represent the prepaid interest on the loan. The interest rate decreases according to the number of discount points the home buyer purchases. Depending on how much the homebuyer wants to lower the interest rate, they can pay for the mortgage points. Discount points and origination points are both paid at closing.
Discount points are upfront payments to reduce the interest rate for the entire mortgage. Origination points are used to cover the overhead costs of the mortgage. For example, if someone is borrowing $200,000 and the lender is charging 1.5 origination points, the borrower will have to pay $3000 in origination points.
Negative Discount Points
Lenders sometimes offer discount points in reverse, called negative discount points. With discount points, the borrower pays the lender to lower the mortgage rates. With negative discount points, the lenders offer points to qualified borrowers to help them reduce the upfront closing costs. This is called a ‘cash rebate,’ which the lender gives to the borrower. However, unlike the discount point, the negative discount points increase the interest during the loan term.
One negative point is equal to 1% of the overall cost of the home loan. Negative discount points are helpful for borrowers who don’t have enough cash to pay for the upfront costs. For this reason, the mortgage is also called a no-cost mortgage. Whereas, with discount points, the borrower can pay more upfront costs and reduce their mortgage interest rate on the mortgage for the future.
Discount Points Examples
Suppose Tom purchases a property that costs $250,000 after a down payment. The mortgage has an interest rate of 4.5%. At this interest rate, Tom has to pay $1,266.71 monthly. Tom thinks that these monthly payments are too high for him. He believes that he won’t be able to afford higher monthly payments in the future. So, he decided to purchase mortgage points. He bought two mortgage points which are as follows:
|Cost per point||Monthly Payment||Savings|
|0 Points (4.5% rate)||$0||$1,266.71||$0|
|1 Point (4.25% rate)||$2500||$1,229.85||$13,270.88|
|2 Points (4% rate)||$5000||$1,193.54||$26,343.01|
John purchased 2 mortgage points because, at that time, he had enough money. After purchasing mortgage points, he can make significant savings in the future. If he hadn’t purchased mortgage points, the mortgage would cost $26,343.01 more during the entire period.
When are Discount Points Worth it?
Whether purchasing discount points is worth it depends on the borrower’s current situation. Discount points help lower the interest rates, especially if the home buyer plans to live in the house for a long time. The home buyer must calculate the break-even point and decide whether the discount points are worth it. The following are the conditions in which discount points are worth it:
To Lower the Monthly Interest Rates
Buying discount points is helpful if the borrower wants to lower the interest rates. The borrower might not qualify for a lower interest rate if they have a bad credit score. With a bad credit score, a borrower will get a higher interest rate as the lender considers the borrower risky. Thus, one way to get a lower interest rate is by purchasing a prepaid interest in the form of discount points.
To Reduce Monthly Payments
If a home buyer thinks they won’t be able to pay huge monthly payments on the mortgage, they should consider purchasing discount points. When someone purchases discount points on the loan, they pay for the interest which lowers the interest rate. A low interest rate means low monthly payments.
Extra Cash for Purchasing Discount Points
Another situation in which the discount points are worth it is when the borrower has extra cash. If the borrower can pay for the discount points without hurting their budget, then they must consider this option. Having extra cash at the time of closing costs will help the borrower purchase discount points and then they can benefit from lower monthly payments during the entire mortgage term.
Plans to Keep the Home for a Long Time
If the borrower plans to keep the home for a long time, then purchasing discount points is a good option. The borrower must calculate the break-even point and then decide if they should purchase discount points or not.
When Are Discount Points Not Worth It?
Discount points are not worth it if the borrower can’t afford a higher upfront cost. The main disadvantage of purchasing discount points is that it increases the initial upfront cost of the mortgage. Discount points are included in the closing costs, and if there are more discount points, the closing cost will increase.
Purchasing mortgage points also means that you have tied up your cash, which could be used for other expenses. Thus, discount points are not worth it if you’re planning for a short-term mortgage or planning to move soon. Discount points are not a good option if you plan to refinance the mortgage too.
Frequently Asked Questions
Can the Borrower Negotiate Points on a Mortgage?
Discount points and origination points are negotiable. However, sometimes the lender might not successfully negotiate discount points. Whether the borrower purchases the points or not depends on the borrower. Generally, when the borrower negotiates the discount points, they demand a lower interest rate during a mortgage’s lifespan. To negotiate points on a mortgage, the borrower must shop around. They must consult with a loan officer who can help them get a better deal.
What are the Alternatives to Discount Points?
One alternative to discount points is just making a larger down payment. If the borrower makes a larger down payment, they can reduce their mortgage balance which will reduce the monthly payments. Besides that, the borrower can also choose a shorter mortgage term, reducing the risk for the lender. Seeing the reduced risk, the lender might offer a lower interest rate to the borrower.
Are Discount Points Tax Deductible?
Discount points are tax deductible, but it depends on the deductions that the borrower claims on their federal income taxes. Since the cost of the discount points represents prepaid mortgage interest, they can be deducted from the taxes, similar to the mortgage interest. According to the IRS, if the borrower can deduct all the interest on their mortgage, they may be able to deduct all the discount points on the mortgage.
How Many Mortgage Points Can One Buy?
The number of mortgage points the borrower can buy depends on the lender. Mostly one-point, two-point, or three-point discount points are the most common. The number of points the borrower can purchase depends on the upfront cash they can pay to the lender. The more mortgage points, the higher the closing costs. It also depends on how much the borrower wants to lower their interest rates.
What to Know for the Real Estate Exam
Discount points or mortgage points have great advantages for lenders and borrowers. The lenders get upfront cash in the form of the cost of mortgage points, and they don’t have to wait for interest payments for many years. On the other hand, borrowers can benefit from lower interest rates for the entire mortgage term.
Lower interest rates mean lower monthly payments and significant savings on the mortgage. The longer the borrower plans to own the home, the better it is to purchase discount points. I hope you now understand how discount points work and how they can benefit home buyers. If you want to learn more about such real estate terms, go through this extensive collection of Real Estate Definitions.