Discount points

What Are Discount Points?

Discount points are a form of prepaid interest paid by a borrower to a lender at the time of closing a real estate loan, typically a mortgage. In the realm of real estate finance, these upfront fees are exchanged for a reduction in the interest rate on the loan. Each discount point generally costs 1% of the total loan amount and is paid as part of the closing costs. By "buying down" the interest rate, borrowers aim to reduce their monthly mortgage payments over the life of the loan.

History and Origin

The concept of discount points as a mechanism to adjust the yield on a mortgage loan has been an integral part of real estate finance for many years. Lenders offer discount points to provide flexibility in loan structures, allowing borrowers to choose between paying more upfront for a lower long-term interest rate or accepting a higher interest rate with fewer initial costs. Historically, these points have served as a way for lenders to receive an immediate cash payment, enhancing their liquidity, while also offering borrowers a path to potentially lower overall interest costs, provided they hold the loan for a sufficient period. The Consumer Financial Protection Bureau (CFPB) has been monitoring trends in discount points, noting their increased use during periods of rising interest rates, suggesting that borrowers may be more inclined to pay these upfront fees to secure lower monthly payments when rates are generally high.¹⁵ The agency also highlights that the financial tradeoffs involved are complex for consumers.¹⁴ Similarly, the Federal Reserve Bank of Philadelphia has discussed how discount points can provide benefits to both lenders and borrowers, emphasizing the importance of ensuring that such points are not "unearned" and genuinely result in an interest rate reduction.¹³

Key Takeaways

• Discount points are upfront fees paid to a mortgage lender to secure a lower interest rate on a loan.
• One discount point typically equals 1% of the total mortgage loan amount.
• Paying discount points can result in lower monthly mortgage payments and potentially significant savings on interest over the loan's term.
• The benefit of paying discount points depends on how long the borrower keeps the mortgage, often determined by a "break-even point."
• In some cases, discount points may be tax-deductible as prepaid interest.

Formula and Calculation

The cost of discount points is directly tied to the loan amount.
One discount point is equivalent to 1% of the principal loan amount.

For example, if a borrower takes out a mortgage for $300,000, one discount point would cost $3,000 (( $300,000 \times 0.01 = $3,000 )). The reduction in the interest rate per point can vary by lender, but it is commonly between 0.125% and 0.25% per point.

Interpreting Discount Points

Interpreting discount points involves evaluating the trade-off between an upfront cash outlay and long-term savings. When considering whether to pay discount points, a borrower effectively "buys down" their future interest payments. This strategy is most beneficial when a borrower plans to keep the mortgage for an extended period, allowing the cumulative savings from lower monthly payments to exceed the initial cost of the points.

A crucial concept in this evaluation is the break-even point. This is the length of time it takes for the savings from the reduced interest rate to equal the cost of the discount points. If a borrower sells their home or decides to refinance the loan before reaching this break-even point, they may not realize a net financial benefit from paying the points. Conversely, holding the loan past the break-even point leads to net savings. The Consumer Financial Protection Bureau (CFPB) notes that borrowers typically only benefit from discount points if they maintain their mortgage long enough for the interest savings to surpass the upfront cost.¹²

Hypothetical Example

Consider a hypothetical scenario where Sarah is obtaining a $300,000 mortgage.

• Option A: No discount points. The lender offers a 7.00% annual interest rate.
• Option B: Pay two discount points. The lender offers a 6.50% annual interest rate.

If Sarah chooses Option B, the cost of the two discount points would be:

Sarah would pay an additional $6,000 at closing.

Now, let's compare the monthly payment for a 30-year fixed-rate mortgage:

• Option A (7.00%): The principal and interest payment would be approximately $1,995.91.
• Option B (6.50%): The principal and interest payment would be approximately $1,896.20.

By paying $6,000 upfront, Sarah reduces her monthly payment by approximately $99.71 (( $1,995.91 - $1,896.20 )). To find the break-even point, divide the cost of the points by the monthly savings:

If Sarah keeps the loan for more than five years, she will save money overall. If she pays off the loan or refinances within five years, she will have spent more money upfront than she saved in interest.

Practical Applications

Discount points are commonly encountered in various real estate and lending scenarios. They are primarily used in:

• Home Purchases: Borrowers can opt to pay discount points to reduce the interest rate on their new home purchase loan, aiming for lower monthly payments.
• Mortgage Refinancing: When homeowners refinance an existing mortgage, they might pay points to secure a lower rate than their current one, especially if prevailing rates have fallen or their financial situation has improved.
• Loan Qualification: In some cases, reducing the monthly payment through discount points can help a borrower meet debt-to-income ratio requirements, making it easier to qualify for a loan. This is particularly relevant for borrowers seeking loans like a Federal Housing Administration (FHA) loan-loan), where a lower debt-to-income ratio can facilitate approval. The CFPB observed that borrowers with lower credit scores were more likely to pay discount points, especially for FHA loans, suggesting lenders use points to help these borrowers qualify by lowering monthly payments.¹¹,¹⁰

Furthermore, discount points can be a significant consideration for tax purposes. According to the Internal Revenue Service (IRS) Publication 936, discount points paid on a mortgage used to buy or build a principal residence may be fully deductible in the year they are paid, provided certain conditions are met. Points paid to refinance a mortgage, however, generally must be deducted ratably over the life of the loan.⁹,⁸ For detailed information on deducting mortgage points, taxpayers should refer to IRS guidelines.⁷

The prevalence of discount points can also be influenced by broader economic conditions. For instance, the Consumer Financial Protection Bureau noted a significant increase in the percentage of homebuyers paying discount points between 2021 and 2023, a period marked by rising interest rates.⁶,⁵ This trend indicates that as interest rates climb, more borrowers are willing to pay upfront fees to mitigate the impact of higher rates on their monthly payments.

Limitations and Criticisms

While discount points offer the potential for long-term savings, they come with certain limitations and criticisms. The primary drawback is the upfront cost. Borrowers must have sufficient cash available at closing to pay these fees, which can add thousands of dollars to the initial expenses of a home loan. This additional financial burden can be a barrier for some prospective homeowners, particularly those with limited savings.

Another significant limitation relates to the duration of the loan. The benefit of paying discount points diminishes, or even disappears, if the borrower pays off the mortgage early or refinances before reaching their break-even point. In such scenarios, the upfront cost of the points may outweigh any interest savings realized. This risk is amplified in volatile interest rate environments where future refinancing opportunities are uncertain. The Consumer Financial Protection Bureau has highlighted that "the financial tradeoffs involved in discount points are complex, creating risks for consumers," particularly if they do not keep the mortgage long enough to recoup the upfront cost.⁴

Furthermore, the effectiveness of discount points in lowering the interest rate is not standardized. The amount by which a loan's interest rate is reduced for each point paid can vary among lenders, making it essential for borrowers to compare offers carefully. There can also be concerns about "unearned discount points," where a borrower pays for points but does not receive a genuine reduction in the interest rate, a practice that regulatory bodies like the Federal Reserve Bank of Philadelphia have warned against due to compliance implications.³ Borrowers should also be aware that the overall amortization schedule of the loan will determine how interest accrues, regardless of the initial rate reduction from points.

Discount Points vs. Origination Fees

Discount points and origination fees are both upfront costs associated with obtaining a mortgage, but they serve different purposes. The distinction often causes confusion for borrowers.

• Discount Points: These are specifically paid to "buy down" the interest rate on the mortgage. By paying discount points, a borrower reduces the stated interest rate for the life of the loan, leading to lower monthly payments. They are essentially prepaid interest.
• Origination Fees: These are fees charged by the lender for processing, underwriting, and closing the loan. They cover the administrative costs of creating the loan and do not directly reduce the interest rate. While also expressed as a percentage of the loan amount (e.g., "1 origination point"), their purpose is to compensate the lender for their services rather than to reduce the borrower's interest rate. Not all lenders charge origination fees, and sometimes lenders may offer loans with no or reduced closing costs, often compensating with a higher interest rate.²

Both discount points and origination fees are typically included in the closing costs that a borrower pays when the loan is finalized.

FAQs

Are discount points always worth it?

Not always. Discount points are most beneficial if you plan to keep your mortgage for a long time. You need to calculate your break-even point to determine how long it will take for the interest savings to offset the upfront cost of the points. If you sell your home or refinance before reaching this point, you may not save money.

Can I finance discount points?

Typically, discount points are paid upfront at closing and are not financed into the loan amount directly. However, in certain loan structures or negotiations, some lenders might allow them to be rolled into the total loan, which would increase the principal and accrue interest. This practice is less common and might negate some of the savings benefits.

Are discount points tax-deductible?

Yes, in many cases, discount points can be tax-deductible. If they relate to a mortgage for your principal residence used to buy or build the home, they may be fully deductible in the year paid. For refinanced mortgages or loans on second homes, they are generally deducted ratably over the life of the loan. It's advisable to consult IRS publications or a tax professional for specific guidance.

Do mortgage rates affect the decision to pay discount points?

Yes, the prevailing interest rate environment can significantly influence a borrower's decision to pay discount points. When interest rates are high, borrowers may be more inclined to pay points to achieve a lower rate and more manageable monthly payment. Conversely, when rates are low, the incentive to pay points might be less, as the potential savings from buying down an already low rate could be minimal or take longer to realize. The Federal Reserve's monetary policy, while not directly setting mortgage rates, can influence the overall rate environment.¹