As you close on the mortgage for your home, your lender may ask if you want to pay discount points.
This is an optional fee borrowers can pay upfront to lenders in exchange for a reduced interest rate over the life of the loan. In other words, you’re paying a chunk of your interest costs upfront to lower your monthly mortgage payment.
The cost of points is based on the amount you borrow. Each point costs 1 percent of the loan amount. Therefore, if you borrow $200,000 for a home, each discount point will cost $2,000.
How much each point will reduce your interest rate will depend on your lender. In most cases, a point will reduce your interest rate by a quarter of a point (0.25) to three-eighths (0.375).
For example, if you were offered a rate of 5 percent on a 30-year fixed physicians mortgage loan, paying one discount point could reduce that to 4.75 percent.
In that scenario, if you borrowed $300,000 for a home loan, your monthly principal and interest payment would be $1,610 at 5 percent interest. A discount point would cost you $3,000 upfront, which would lower your monthly payment to $1,564, a savings of $46.
If you purchased three discounts points, you would spent $9,000 to potentially lower your interest rate to 4.25 percent. Your monthly principal and interest payment would drop to $1,475, a savings of $135 a month.
The question would be whether you want to pay $3,000 upfront at closing to save $46 on your monthly mortgage payment, or $9,000 to save $135 a month. For most, the upfront cash could be better used to increase a downpayment, or for moving expenses.
Depending on how much a point will reduce your interest rate, it may take five to six years before you break even on paying upfront discount points. Therefore, buying points won’t benefit you if you sell the home with five years of purchase, which is common for first-time homebuyers. The longer a borrower lives in the home, the more they benefit from buying discount points.
For discount points on an adjustable rate mortgage (ARM), the lender may only lower the interest rate during the initial fixed-rate period. Other lenders will credit your upfront points so that if rates go up during the adjustable period, your rate will be lower based on the points you initially purchased.
Another type of mortgage point a lender may offer is a negative point. This may also be called a rebate point, a reverse point, or an origination point.
With negative points, a lender provides a credit that covers a broker fee or closing costs. In exchange, the borrower pays a higher mortgage rate than they otherwise would have qualified for.
For example, a negative point for a $300,000 mortgage provides a $3,000 credit that can go toward closing costs or other fees. The buyer, in return, will have their mortgage rate increased, for example, from 5 percent to 5.25 percent.
In this case, your monthly principal and interest payment would go up from $1,610 to $1,656. If you don’t have or don’t want to use cash to pay closing costs, it may be worth it to pay an extra $46 a month on your loan.
If you itemize deductions when you file your taxes, then you will be able to deduct your discount points. That’s because the IRS treats them the same as an interest payment.
Whether you can deduct the cost of an origination point depends on what it was used for. If it was used to obtain the mortgage, the origination fee is tax deductible. But if it covers the closing costs that are itemized on the settlement statement — notary fees, preparation costs, inspection fees — the cost of the origination point is not deductible.
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Joel Palmer is a writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.