What Are Discount Points

Image source: Getty Images.

A discount point is a way to make a pre-paid interest payment on mortgage for lower interest rates. A lender might offer a borrower the option to buy a discount point at a price equal to one percentage point of the loan amount, in exchange for 0.25 percentage point reduction in the interest rate on the loan.

Over the 15 or 30 year life of a mortgage, slashing your interest rate by as little as 0.25 percentage points can potentially save you thousands of dollars more than the cost of the discount point. But it isn't the sure bet that it may seem to be on paper.

How discount points work

A point will cost you 1% of the mortgage amount, and reduce the interest rate on the mortgage by 0.25%. You can buy multiple points, and reduce the rate even further. Good deal? Bad deal? Like anything, it depends.

Let's use a simple example to see how a discount point affects a typical 30-year mortgage. Below, I've calculated the monthly payment on a 30-year mortgage in the amount of $100,000. The first scenario assumes you do not buy any discount points, whereas the second scenario assumes you buy a point.

Metric 

No Points

1 Point

Mortgage amount

$100,000

$100,000

Points (cost)

None ($0)

1 ($1,000)

Rate

3.75%

3.5%

Monthly payment

$463

$449

Notice that buying a point reduces your monthly payment from $463 to $449 per month, thus saving you $14 per month every month for the 30-year life of the loan, at the cost of $1,000 upfront. One way to determine if this is a good deal is to consider the "breakeven" time horizon, or the amount of time it would take you to recoup the savings from buying the point.

The breakeven point can be calculated by dividing the $1,000 cost of the point by the $14 you will save each month. In this case, you would break even after making 72 mortgage payments. After 72 payments (6 years), you will have saved $1,008 from lower monthly payments, exceeding the original $1,000 cost of the discount point.

The calculator below can help you determine the breakeven point based on your own personal scenario.

 

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

Should you buy a discount point?

It's important to consider that buying a discount point is not a risk-free way to save money. The savings you receive from a discount point will only exist for as long as the mortgage does. And while it may seem obvious to buy a discount point on a 30-year mortgage to get 30 years of savings, very rarely do 30-year mortgages live to the full length of the contract.

People move. A lot. Census data suggests that the average American moves about 11.7 times in his or her lifetime, and about nine times after reaching 18 years of age. Homeowners are probably less likely to move than renters, but the average American does a whole lot of moving around. Unfortunately, moving negates any future benefits of a discount point you have already paid for, as most people sell their home (and repay their existing mortgage) when they move into a new home. 

Historical

Refinancing a mortgage also negates the benefit of discount points. Refinancing is nothing more than taking out a new mortgage to pay off an existing mortgage. As interest rates have generally declined over the past few decades, it's safe to say that buying discount points was a losing proposition for most home buyers. Most people likely refinanced well before the breakeven on their discount points, while others almost certainly prepaid their mortgage to move to a new home.

High-income borrowers who itemize their deductions will find discount points a little more attractive, as discount points are tax deductible in the same way mortgage interest is. However, whether you're in the highest tax bracket or the lowest, you'll still lose the future benefit of lower payments if you prepay your mortgage because you move or refinance for better terms.

A safer bet than discount points

Buying discount points is risky, and there may be a better option that will reduce your mortgage payment without the risk of making a bad decision. Rather than buy a discount point for one percent of the mortgage amount, a better option might be to simply use the money to make a bigger down payment.

The table below adds the "borrowing less" scenario into consideration.

 Metric

No Points

Borrowing Less

1 Point

Mortgage amount

$100,000

$99,000

$100,000

Points (cost)

None ($0)

None ($0)

1 ($1,000)

Rate

3.75%

3.75%

3.5%

Monthly payment

$463

$458

$449

By borrowing $99,000 instead of $100,000, your mortgage payment will drop by $5 per month. Sure, that's not the $14 in monthly savings you'll get from buying a discount point for $1,000, but it comes with much less risk. You won't necessarily lose your home equity simply because you move, or because you refinance, but you will certainly lose your discount points in those scenarios. 

Frankly, for the average American, buying discount points simply doesn't make much sense. The cost is a certain amount paid upfront in exchange for an uncertain amount of savings over a period of time as long as 30 years. 

If nothing else, a little cynicism is helpful here. Lenders are in the business of making money, and they wouldn't sell discount points if it weren't profitable. Some borrowers win, and some lose, but lenders have almost certainly made a fortune selling discount points to borrowers who have moved or refinanced before saving much in the way of interest.

 

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.