Explaining mortgage discount points in plain English
Discount points are a one-time, upfront mortgage closing cost which give a mortgage borrower access to “discounted” mortgage rates as compared to the market. The IRS considers discount points to be prepaid mortgage interest, so discount points can be tax-deductible. In general, one discount point paid at closing will lower your mortgage rate by 25 basis points (0.25%).Verify your mortgage eligibility (May 25th, 2018)
What are mortgage discount points?
When your mortgage lender quotes you current mortgage rates, the rate is typically quoted in two parts.
The first part is the mortgage rate, and the second part is the number of discount points required to get that rate.
You’ll notice that, in general, the higher the number of discount points you’re charged, the lower your mortgage rate quote will be.
Discount points are fees specifically used to buy-down your rate. This makes them different from “origination points”, which are fees that a bank charges to “do your loan”.
On a settlement statement, discount points are sometimes labeled “Discount Fee” or “Mortgage Rate Buydown”. Each discount point cost one percent of your loan size.
Assuming a loan size of $200,000, then, here are a few examples of how to calculate discount points for a mortgage loan.
- 1 discount point on a $200,000 loans costs $2,000
- 0.5 discount points on a $200,000 loan costs $1,000
- 0.25 discount points on a $200,000 loan costs $500
Discount points can be tax-deductible, depending on which deductions you can claim on your federal income taxes.
Discount points paid on a home purchase mortgage loan can be 100% deductible in the year in which they’re paid. Discount points on a home refinance mortgage loan cannot.
The tax deduction for points paid on a refinance loan is spread over the life of the loan. A homeowner paying points on a 30-year mortgage loan can claim 1/30 of the points paid as a deduction annually.
If you choose to pay discount points in conjunction with your mortgage, you’ll want to communicate with your tax preparer in order to maximize federal income tax deductions.
In 2015, according to Freddie Mac, the typical fixed-rate mortgage loan carried an accompanying 0.6 discount points. The typical adjustable-rate mortgage (ARM) carried an accompanying 0.5 discount points.Verify your mortgage eligibility (May 25th, 2018)
How discount points affect your mortgage rate
When discount points are paid, the bank collects a one-time fee at closing in exchange a lower mortgage rate to be honored for the life of the loan.
The banks consider this payment to be “prepaid mortgage interest”. Meanwhile, mortgage interest is tax-deductible for eligible tax-filers so, for many mortgage borrowers, there’s a tax advantage to paying discount points.
However, you don’t pay discount points to get the tax break — you pay them to get the mortgage rate break; and, how much of a mortgage rate break you get will vary by bank.
This is one of the reasons why it’s important to shop for your best mortgage rate. Different banks will offer different sets of discounts in exchange for paying points.
As a rule of thumb, paying one discount point lowers a quoted mortgage rate by 25 basis points (0.25%). However, paying two discount points, however, will not always lower your rate by 50 basis points (0.50%), as you would expect.
Nor will paying three discount points necessarily lower your rate by 75 basis points (0.75%)
As an example of how discount points may work on a $100,000 mortgage :
- 3.50% with 0 discount points. Monthly payment of $449.
- 3.25% with 1 discount point. Monthly payment of $435. Fee of $1,000.
- 3.00% with 2 discount points. Monthly payment of $422. Fee of $2,000.
You’ll note that when you pay discount points come, it costs at a cost, but it also generates real monthly savings.
In the above example, the mortgage applicant saves $14 per month for every $1,000 spent at closing. This creates a “breakeven point” of 71 months.
Every mortgage loan will have its own breakeven point on paying points. If you plan to stay in your home beyond the breakeven and — this is a key point! — don’t think you’ll refinance before the breakeven hits, paying points may be a good idea.
Otherwise, points can be a waste.
Banks know this and will sometimes use a mortgage shopping tool known as “APR” to make a loan with discount points look more attractive than it really is.
APR, which stands for Annual Percentage Rate, is a government calculation which is meant to show the long-term cost of holding a mortgage; and paying points lowers long-term costs in the form of a lower mortgage rate.
But APR also assumes you’ll hold your loan for 30 years. Very often, you will not, which nullifies the APR math.
This is why it’s important to remember that your APR is not your mortgage rate. Your mortgage rate is your mortgage rate.
Shopping for a mortgage using the “Lowest APR” method rarely a good plan. It uses discount points against you.Verify your mortgage eligibility (May 25th, 2018)
“Negative” discount point loans (zero-closing cost)
Another helpful aspect of discount points is that lenders will often offer them “in reverse”.
Instead of paying discount points in order to get access to lower mortgage rates, you can receive points from your lender and use those monies to pay for closing costs and fees associated with your home loan.
The technical term for reverse points is “rebate”.
Mortgage applicants can typically receive up to 5 points in rebate. However, the higher your rebate, the higher your mortgage rate.
Here is an example of how rebate points may work on a $100,000 mortgage :
- 3.50% with 0 discount points. Monthly payment of $449.
- 3.75% with 1 discount point. Monthly payment of $463. Credit of $1,000.
- 4.00% with 2 discount points. Monthly payment of $477. Credit of $2,000.
Homeowners can use rebates to pay for some, or all, of their loan closing costs. When you use a rebate to pay for all of your closing costs, it’s known as a “zero-closing cost mortgage loan”.
Zero-closing cost mortgages reduce the amount of cash required at your closing.
Buyers who are using low-or no-downpayment mortgages may find this option appealing — especially if they’re worried about having money in savings for emergencies or other life events.
When you do a zero-closing cost refinance, you can stay as liquid as possible with all of your cash in the bank.
Rebates can be good for refinances, too.
Using rebates, a loan’s complete closing costs can be “waived”, which allows the homeowner to refinance without increasing its loan size.
When mortgage rates are falling, zero-closing cost mortgages are an excellent way to lower your rate without paying fees over and over again. You can refinance three times in a year or more and never pay fees to the bank.
Zero-closing cost loans minimize interest rate risk against falling rates. If you’re refinancing or buying a home, be sure to get a zero-closing cost rate quote.
What are today’s mortgage rates?
Paying discount points (or receiving them) is a financial decision which varies by borrower and loan.
Get today’s live mortgage rates now. Your social security number is not required to get started, and all quotes come with access to your live mortgage credit scores.Verify your mortgage eligibility (May 25th, 2018)
The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.