About Mortgage Discount Points
Discount points are a common feature of mortgages, but many borrowers don't understand them. How do they work?
Discount points are actually a type of pre-paid interest. So by paying part of your interest up front, you can reduce your interest rate. There are technical reasons why it makes sense for lenders to allow this, but as a borrower, the key thing for you to know is that buying points can save you money over the long haul – but only if you stay in the home long enough for your savings from a lower mortgage rate to exceed what you paid for the points up front.
The pricing for discount points is always the same – one point costs exactly 1 percent of your loan amount. That's why they're called points – in financial terminology, a "point" is short for "percentage point" or 1 percent of a given amount. So if you buy two points on a $200,000 mortgage, the cost will be $4,000.
How much each point you buy will reduce your rate varies from lender to lender, but is typically about one-eighth to one-quarter of a percent. So buying two points might reduce your mortgage rate by as much as one-half percent.
You can pay for your mortgage points up front, but they're usually rolled into the cost of the loan. So if you buy two points, instead of borrowing $200,000, you'd end up borrowing $204,000. But your lower rate means a lower monthly payment, so you start saving money. You're also paying less in interest every month, so more of your mortgage payment goes toward reducing principle.
The key to whether it's worth buying points or not is called the "break-even point." That's the point where you've saved enough by paying for points to offset what you paid for them in the first place.
For example, paying $4,000 to save $40 a month probably isn't worth it if you move out of the house in two years.
Figuring the break-even point isn't a straightforward decision. In the example above, you'd think the calculation would be: $4,000 divided by $40 a month = 100 months to break even (eight years, four months). In reality, it's much less than that – a little less than five years, assuming a half-percent reduction from 4.25 to 3.75 percent, owning to the more rapid reduction in loan principle
Using the Mortgage Points Calculator
The calculator assumes that you'll roll the cost of your points into the mortgage. Enter the total cost of the mortgage with points in the box marked "Mortgage amount." The calculator will determine the size of the loan without points for comparison.
- "Term in years" is the length of the mortgage.
- Enter the number of points under "Discount points" – note that you can enter negative points as well, to reduce your closing costs in return for a higher rate. Fractional points can be entered.
- "Points rate" is your rate with discount points; "Interest rate" is your rate without points.
- "Years in home" is how long you expect to stay in the home. Based on this figure, the calculator will determine how much your will save or it will cost you to pay for points. To find your break-even point, use the green triangle slider to find the point you go from costs to savings.
- "View report" will provide you with an amortization schedule comparing the loan with and without points.
(You can buy fractional points too – such as 0.43 points or 1.27 points. In fact, most mortgage rates you see advertised will have some fraction of a point or more included with them. It allows lenders to round off a rate to a standard fraction, like 3.75 percent, rather than charging something like 3.813 percent, to reflect the cost of credit.)
Wondering what kind of mortgage rate you can get? Use the "Get Free Quote" button at the top of the page to get personalized quotes from lenders for a home loan, refinance or home equity loan.