What Are Discount Points – and Could They Save You Money?

When buying a home, you'll look at plenty of interest rates and mortgage options to figure out the best way to finance your purchase. Over the course of your research, you might come across the term "discount points."

Discount points are an upfront cost you could pay to get a lower interest rate over the life of your mortgage. You may also come across the term "mortgage points"; discount points are a type of mortgage point (origination points are the other type).

Discount points may work for you if the savings from lowering your interest rate outweigh the cost of paying for the point(s). But first, here's a rundown of what you need to know.

How discount points work

Discount points are essentially mortgage interest that you pre-pay upfront at closing. Typically, one point costs 1% of the total mortgage, and permanently lowers the interest rate anywhere from 0.125% to 0.25%, depending on the type of mortgage. That means if you have a $250,000 mortgage, one discount point would cost $2,500. And if the interest rate without points was 3.5%, paying one point might lower the rate to either 3.375% or 3.25%.

Some lenders offer a fraction of a point; others offer up to three points. Furthermore, the points you pay could be tax-deductible, so consult with your tax advisor to find out if this is the case.

Does it make financial sense for you?

Now that you know what discount points are and how they work, you can figure out the question you've been asking yourself this whole time: will they save you money?

To answer that, you'll need to start by calculating your break-even point. This is when your monthly interest savings equals the upfront cost you'd pay for the discount point(s). You can calculate this using a simple formula:

Let's go back to the example above. If you have a $250,000 mortgage with a 3.5% fixed interest rate over 30 years, your monthly payment (principal and interest) would be about $1,123. If you purchased one discount point for $2,500 and your interest rate dropped to 3.25%, your monthly payment would be about $1,088, which comes to about $35 in savings each month.

So, going back to the formula:

In this scenario, if you didn't plan on living in the home for more than 72 months, a discount point would not fully pay for itself. However, every additional month you live in the home beyond those 72 months would yield savings.

What to remember

Deciding whether to pay discount points really comes down to two factors: how long you plan to live in the home and whether you can afford the upfront cost.

In some cases, it may make more sense to put additional money toward your down payment instead of paying for discount points, especially if it brings your down payment up to the 20% threshold that eliminates the need for mortgage insurance. But no matter the circumstances, the only way to find out if discount points make sense is to speak to your mortgage advisor and take a look at all options available.