Homebuyers

Mortgage Discount Points: How They Can Lower Your Interest Rate and Potentially Save You Money

Right now, everything seems more expensive, from gas to groceries. But there are ways for homebuyers to get discounts, even on their monthly mortgage payments.

Enter mortgage discount points. These “for purchase” points are an investment people can make to “buy down” the interest rate on a mortgage from the outset of the loan.

Since mortgage rates have been hovering over 6% since mid-September 2022, the idea of securing a lower rate may sound very appealing to prospective buyers. But what exactly are mortgage discount points?

“The easiest way to think about mortgage points is that you’re simply paying some of your interest upfront to save money over time,” said Chip Lupo, an analyst for WalletHub. “Mortgage points are a fee, usually 1% of your loan amount per point, that you pay at closing. In return, the lender gives you a lower interest rate on your loan.”

Each point you purchase typically brings your rate down by a quarter of a percentage point.

That lower rate means smaller monthly payments and less interest paid over the life of the mortgage. But are the savings really worth the upfront costs? Keep reading to get the lowdown on lowering your rate via mortgage discount points.

What are discount points on a mortgage?

What are mortgage points? Mortgage points are essentially a trade-off homebuyers make with their lender. 

A potential homebuyer seeking a lower mortgage rate will purchase mortgage points that they can then effectively swap for a reduction in their loan’s interest rate.

How much do these points cost? It depends on the lender you select, how much you’re borrowing, and how low you want your interest rate cut. A good rule of thumb, however, is that one mortgage point will run around 1% of the loan amount and garner roughly a .25% point reduction on the loan’s interest rate.

Let’s say you’re looking to buy a $500,000 home with 20% down, meaning you still need to borrow $400,000. If each discount point costs 1% of the loan, then in this case, one mortgage point will be $4,000.

If the initial mortgage rate is 6% and you want it to be 5.5%, you will need to buy two points (if each point is worth a quarter-point rate reduction) for $8,000.

How do I determine if buying mortgage points will save me money?

The premise of mortgage discount points is that you agree to pay more now to save more later.

But how do you know if you’re actually saving money when you’re spending money on the points? For starters, make sure you don’t plan to sell your home anytime soon. The longer you stay in the property, the more the points pay off.

“Mortgage points lower your interest rate and monthly payment, but the benefit really only kicks in after your savings from the lower monthly payments exceeds the amount you paid for the points,” said Lupo.

In other words, once you reach your breakeven point, then you reap the rewards of this trade.

How do you determine your personal breakeven point? Try the following calculation for any amount you’re considering:

• Step 1: Determine the total cost of the points. If each point equals 1% of the loan amount, you can calculate the total cost by multiplying the mortgage amount by 0.01, then by the number of points you plan to purchase.
• Step 2: Compare monthly payments. Subtract the mortgage payment with points from the original payment without points to determine your monthly savings.
• Step 3: Divide the total upfront cost of the points by the monthly savings. The result is the number of months it takes to recover the cost, or your breakeven point.

Keep in mind that it is possible to buy fractions of points as well. You’ll want to determine your best breakeven point by plugging different mortgage discount point options into this equation.

“This can be done over and over for any rate buydown scenario,” said Greg Filzen, a senior loan consultant at New American Funding who is based in Northbrook, Ill.

However, paying for several points (more than 1 or 1.5) is generally discouraged since rates may drop on their own in the future. Then it may be cheaper to refinance your loan.

“No one can predict rates, and cash used for a large buydown can take much longer timewise to get the payback needed to justify the amount,” said Filzen.

Are there other options beyond mortgage points for rate buydowns?

Mortgage point buydowns tend to be permanent, meaning they exist for the life of the loan. But there are other types of temporary mortgage rate buydowns homebuyers may also wish to explore.

These include adjustable-rate mortgages (ARMs) and buydown loans, both of which help bring down monthly mortgage payments for a finite time frame (typically the first few years of a mortgage).

Adjustable-rate mortgages start with a fixed-interest rate that is generally lower than current rates for the first five to 10 years. After that, they adjust based on current rates, up to a cap, every six months to a year.

With buydown loans (the most common types are 3-2-1 and 2-1 buydowns) your interest rate is reduced for the first few years.

For example, a 3-2-1 buydown reduces your interest rate by three percentage points the first year, two percentage points the second year, and one percentage point the third year, before returning to the original fixed rate.

So, if you took out a loan with a 6.5% mortgage rate, your rate would be 3.5% in the first year, 4.5% in the second, 5.5% in the third, and then 6.5% for the remainder of the loan.

“The key difference from mortgage points is that the savings are front-loaded and temporary, rather than permanent,” said Lupo. “Temporary buydowns are often paid for by sellers or builders as an incentive to help reduce early monthly payments.”

Both of these options can help new homebuyers afford homeownership at the beginning of their mortgage, when money may be tighter after paying down payment and closing costs.

When is purchasing mortgage points a smart move?

 To decide if temporary buydown options are better for you than mortgage points, you need to focus on the total cost over the time you expect to hold the loan, not just the initial monthly payment.

“If you expect to move, refinance, or see income growth in the near term, a temporary buydown or ARM may be more useful because you benefit from lower payments early without paying for long-term rate reductions,” said Lupo.

“If you plan to stay in the home long-term and want payment stability, mortgage points may be more attractive because the savings last for the life of the loan,” said Lupo.

In other words, for a mortgage point purchase to make sense, the breakeven point needs to align with your future plans.

Greg Filzen NMLS # 354287