What are Discount Points and Should You Buy Down Your Rate?

Mortgage loans are more expensive lately due to higher interest rates. One way you can bypass the pain of higher rates is to buy down your rate via discount points.

A discount point allows you to pay a cost upfront in exchange for slightly lowering your rate. But discount points are pricey, and they may not lower your rate as much as you would like.

Explore how discount points work, their benefits and disadvantages, worthy prospects for pursuing discount points, and alternative options to ponder by reading on.

Discount points explained

If you want to finance the purchase of a home or refinance your existing mortgage, expect to pay a higher-than-desired interest rate nowadays. Banks and lenders have increased rates significantly over the past several months (although, thankfully, they are starting to come down again).

This can make it more costly to finance a home.

But one method for paying less in interest over time on your mortgage loan is to purchase one or more discount points. A discount point is a fee paid to your lender to lower the interest rate on your loan.

This fee is paid upfront at closing or can be bundled into your loan. Typically, the cost of one discount point is 1% of your loan amount. Paying this fee will likely lower your rate between 0.125% and 0.25%.

“The appeal of a discount point is that the buyer pays a certain percentage of the interest alone so that they can secure much more reduced rates throughout the life of their loan,” says real estate agent Rinal Patel. 

Imagine you want to borrow $300,000 for a home purchase. Buying one discount point will cost you $3,000. In exchange, the lender agrees to lower your fixed interest rate by 0.25% on your new 30-year mortgage loan, reducing the rate from 7.0% to 6.75%.

Here, you would pay $1,945 monthly in principal and interest payments versus $1,995 if you had stuck with the 7.0% rate, saving you $50 per month and over $18,000 in total interest over the 30-year life of the loan. 

Keep in mind that the amount your interest rate will decrease depends on the particular lender, the kind of mortgage loan you choose, and the overall mortgage market, according to the Consumer Financial Protection Bureau. 

The pros and cons of discount points

The major advantage of paying for discount points? By buying down your interest rate you can, as demonstrated in the example above, pay less in total interest over the life of your loan.

“Also, by purchasing discount points, you can increase your chances of qualifying for a larger loan, if that’s your goal,” says Patel. 

A smaller benefit is that what you pay for each discount point can be deducted from your taxable income, meaning you may pay less in taxes when it’s time to file your annual tax return.

On the flip side, shelling out all that cash in a lump sum at closing can deplete your savings or financial reserves or make it more challenging to afford your down payment – unless your lender agrees to roll the discount point cost into your loan, which may not yield the monthly interest savings you had hoped for.

There’s also the risk that you may not recoup the money you spent on discount points by the time you sell your home.

“Consider that, using that $300,000 loan example, it will take 60 months, or five years, to break even on that $3,000 discount point cost,” explains Aaron Gordon, branch manager and senior mortgage loan officer with Guild Mortgage. “You have to plan on staying in your home and with that loan for a while for this to make financial sense. If you plan on remaining in your home for only three or four years, it may not be worth it. Or if you believe interest rates will come down within two to three years and you’ll refinance at that time, you may regret paying for the discount point.”

Gordon recommends asking your lender to show you a breakdown of the costs involved and how long you have to remain in your home/loan for points purchasing to make sense.

Good candidates for discount points

If you have ample funds you can bring to closing and can afford to pay for discount points without severely depleting your savings and monthly budget, buying one or more points can be worth it. That’s assuming you expect to stay put in your home for at least the number of months it will take to break even on the upfront costs.

“It generally takes at least four to five years remaining in place for points to make sense,” Gordon adds.

However, even if you make it past that threshold, “there is no guarantee that your property will build enough equity to recapture those upfront costs when you sell,” cautions Omer Reiner, a Realtor and president of FL Cash Home Buyers LLC. “The best thing to do is take a hard look at your future plans and whether your current finances allow for a larger upfront payment at closing.”

Patel says borrowers who are in between jobs or whose occupations require them to travel constantly should think twice before committing to discount points.

On a positive note, Gordon points out that, per Redfin, a third of all home sellers today are making more concessions to buyers, including paying for discount points.

“I highly recommend discount points if you can get the seller to pay for at least a portion of them,” says Gordon.

Discount point alternatives

The best alternative to purchasing discount points is simply increasing the size of your down payment.

“The effect on your monthly payment won’t be as great if you make a larger down payment as it would if you had purchased points. But with a smaller loan balance, you will build equity sooner,” Gordon continues.

Case in point: Let’s say, using the previous example, you put down $80,000 (an extra $5,000) instead of $75,000 on a home that you need to borrow $300,000 for. If so, your monthly principal and interest payment would be $1,962 (at a 7.0% fixed interest rate) versus $1,945 monthly if you had purchased a $3,000 discount point (bringing the fixed interest rate down to 6.75%).

Here, paying the point would save you $17 per month more, but you would have 21.33% equity in the property right off the bat by increasing your down payment versus 20% equity if you paid the point. 

“Or, you could choose a shorter loan term—say a 20-year term instead of a 30-year loan,” suggests Patel.

Assume you opted for a 20-year mortgage loan for which you put down $75,000 and borrow $300,000 at a 7.0% fixed interest rate. If so, you’d pay $2,325 in principal and interest payments monthly, equating to $380 more per month than if you had stuck with a 30-year loan and paid one point to get the rate down to 6.75%.

But you would pay $142,656 less in total interest over the life of that loan, and pay off your loan 10 years earlier. 

The bottom line

Discount points provide a viable option for paying less interest over time and saving you money in the long run. But you need to carefully consider how long you plan to stick with your mortgage loan so that you can determine if and when you would break even on discount point costs due at closing. 

Consult closely with your lender, real estate agent, tax planner, and trusted financial professional to make a more informed decision about discount points.