How to calculate discount points?

What are Discount Points in a Mortgage?

Discount points, also known as mortgage points, are upfront fees you pay to reduce your mortgage interest rate. This is often referred to as “buying down the rate.” Each point typically costs 1% of your loan amount and can lower your interest rate by about 0.25%, though the exact reduction depends on market conditions and your lender.

• 1 discount point = 1% of the loan amount
• Each point can reduce your rate by 0.25% (approximate)
• Paid at closing as an upfront cost

Buying discount points can help reduce your monthly payment and your total loan cost over time. But it’s not always the best choice for everyone. Let’s explore how discount points work, how much they cost, and, most importantly, how to calculate discount points to see if they make sense for your situation.

How Do Discount Points Work?

When you pay discount points, you’re essentially prepaying interest on your mortgage loan to lock in a lower mortgage rate. This makes sense if you plan to stay in your home for a long time and want to save more money over the life of your loan.

Here’s how discount points work in practice:

• You take out a $300,000 mortgage loan
• You buy 2 points at closing (2% of the loan = $6,000)
• Your interest rate drops from 7% to 6.5%
• Your monthly mortgage payment drops by around $100

Over time, those monthly savings can add up. But there’s a catch: you need to stay in the home long enough to make back the upfront cost.

How Much do Discount Points Cost?

The cost of discount points depends on your total loan amount. Since one point equals 1% of the mortgage, the math is simple.

Use this point calculator formula:

• Discount point cost = Loan amount × Number of points × 1%

Example:

• Loan amount = $250,000
• You buy 1.5 points
• 1.5 × 1% × $250,000 = $3,750

Keep in mind that this is an upfront cost paid at closing and not included in your loan. You should factor this into your overall home loan budget.

When do Discount Points Make Sense?

Discount points are worth considering if:

• You plan to stay in the home for many years
• You can afford the upfront cost
• You want to reduce your monthly mortgage payment
• You’re working with a loan officer who can help you compare scenarios

Let’s break down common situations where paying points might be the smart move:

• Buying your forever home: If you plan to live there 10+ years, points will likely save you money long-term.
• Locking in a rate before a market shift: In uncertain market conditions, locking in a low rate now with points could be wise.
• You have extra cash at closing: If you’re not strapped for cash, investing in a lower rate could be better than putting that money elsewhere.

How to Calculate Discount Points: Step-by-Step

Here’s how to calculate whether paying points makes sense using a simple method:

1. Determine the cost of points
   • Loan amount × # of points × 1%
2. Calculate your monthly savings
   • Compare the monthly payment with and without points
3. Find the break-even point
   • Break-even (in months) = Cost of points / Monthly savings
4. Compare with your plan
   • Will you stay in the home long enough to reach that break-even point?

Example:

• Loan amount: $300,000
• Buy 2 points = $6,000
• Monthly savings: $120
• Break-even: $6,000 ÷ $120 = 50 months (~4.2 years)

If you plan to stay more than 4.2 years, buying points can save you money.

Pros and Cons of Paying Discount Points

Here’s a quick breakdown to help you weigh your options:

Pros:

• Lowers your interest rate
• Reduces your monthly mortgage payment
• Saves money over the long term
• May reduce your annual percentage rate (APR)

Cons:

• High upfront cost
• May not benefit short-term homeowners
• Opportunity cost: money could be used elsewhere
• Not always worth it depending on market conditions

Tip: Ask your loan officer to show side-by-side comparisons for paying vs. not paying points.

Key Considerations Before You Pay for Points

Before you decide to pay for mortgage discount points, ask yourself:

• How long do I plan to stay in the home?
• Can I afford the upfront cost comfortably?
• Do I understand my break-even timeline?
• Will this impact other costs, like mortgage insurance or reserves?

Also, check if the mortgage points are tax-deductible in your situation. That can sweeten the deal even more.

Should You Pay Discount Points?

Knowing how to calculate discount points is essential for making an informed mortgage decision. For long-term homeowners, discount points can be a great way to lower your rate and save thousands of dollars over time. However, if you plan to move or refinance soon, the upfront cost may not be worthwhile.

Need help understanding these mortgage terms?

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