Discount Points

How discount points really work in practice

Discount points are a type of optional closing cost that you can choose to pay in order to secure a lower interest rate. They sit alongside other lender fees on your closing disclosure, but they behave differently because they are tied directly to your interest rate instead of to processing or administration.

Each point typically costs 1% of your total loan amount. For example, on a $400,000 mortgage, one discount point would cost $4,000. In return, your lender reduces the interest rate on the loan, often by about 0.25% per point, although the exact reduction depends on the day's pricing and the specific loan program.

Here is what that means in practical terms:

• Upfront cost: You pay the amount for the points at closing, on top of your down payment and other closing costs.
• Permanent rate reduction: The lower rate generally applies for the entire life of a fixed‑rate loan, not just for a few years.
• Lower monthly payment: Because your rate is lower, your required principal and interest payment goes down.
• Less interest over time: Over many years, even a small rate reduction can reduce total interest by tens of thousands of dollars.

It is important to distinguish discount points from other lender charges that may show up in a "points" section on your paperwork. Some fees, such as origination points, compensate the lender for making the loan and do not reduce your rate. True discount points always buy a lower rate, and you should see that lower rate clearly reflected in your loan estimate or closing disclosure.

Tax rules sometimes treat discount points as prepaid interest, which can affect how and when they may be deductible. The details depend on the type of property, how the loan is structured, and current tax law, so it is wise to confirm the treatment with a qualified tax professional rather than assuming all points are fully deductible in the year you pay them.

When paying for discount points makes (and does not make) financial sense

Because discount points increase what you pay at closing, the key question is whether the upfront cost will be outweighed by future savings. The simplest way to think about this is to calculate your break‑even point and then compare it with how long you realistically expect to keep the loan.

Here is a practical process you can follow:

• 1. Compare offers with and without points. Ask your lender to show you the same loan both ways: one quote with no discount points and one or more quotes with points. Make sure everything else (loan amount, term, and type) is identical.
• 2. Find the monthly savings. Subtract the monthly principal and interest payment at the lower rate from the payment at the higher rate. The result is your monthly savings from buying points.
• 3. Calculate your break‑even timeline. Divide the total cost of the points by the monthly savings. The answer is roughly how many months it will take for your payment savings to repay the upfront cost.

For example, suppose you can pay $4,000 in discount points to reduce your rate so that your payment drops by $90 per month. Divide $4,000 by $90 and you get about 44 months. If you keep the loan longer than that, you come out ahead on payment savings alone. If you sell the home or refinance before then, you will not fully recover the cost through monthly savings.

Beyond a simple break‑even, it is worth thinking about a few other factors:

• How long you expect to keep the loan: If you plan to move or refinance in a few years, paying for points rarely makes sense.
• Cash on hand at closing: Tying up cash in points may not be wise if it would leave you without a healthy emergency fund or if you have higher‑interest debts you could pay down instead.
• Future rate expectations: If you strongly expect to refinance into a lower rate relatively soon, paying for a permanent rate reduction today has less value.
• Tax situation: If points are deductible for you, the effective net cost may be lower, but the benefit still needs to be weighed against the upfront cash required.

Ultimately, discount points can be a smart way to lower the long‑term cost of borrowing when you have the cash at closing and expect to hold the mortgage for many years. They are less attractive when your time horizon is short, your budget is already stretched by down payment and closing costs, or you have better uses for the same dollars. Treat the decision like an investment: understand the cost, calculate the payback period, and only commit if the numbers support your goals.