When you take out a mortgage to purchase a home, your lender will charge you various fees. One of these fees might be "discount points." Discount points are amounts you choose to pay to get a better interest rate. You might hear a lender refer to this fee as "buying down" your interest rate. One point is typically equal to 1% of the loan principal and usually reduces the rate by .25%. So, if you take out a loan with a $200,000 principal balance, each point costs $2,000. Paying one to three points is common on home loans and can easily add up to thousands of dollars. But you might be able to deduct points associated with a home purchase mortgage or a refinance at tax time.
Whether paying for discount points is worthwhile depends on the circumstances. For those who can afford the discount points upfront and intend to live in the property long-term, it often makes sense to pay for them. You need to stay in the property (and not refinance) for long enough to at least break even, preferably longer, so that you'll start saving money. But you should also consider other factors, like:
You have to pay for discount mortgage points at the loan's closing; you can't buy them afterward. Again, one point is typically equal to 1% of the loan principal and generally reduces the rate by .25%. However, one point might lower the rate by more or less than 0.25%, depending on the loan and lender. The more discount points you buy, the lower your interest rate will be, but you usually can't purchase more than four. Most lenders offer two or three points on a loan.
On the flip side, "negative" discount points, sometimes called "rebates" or "yield spread premiums," reduce the amount of cash you need to pay at closing. But then you have to pay a higher interest rate.
Another kind of mortgage points are "origination points" These points don't have anything to do with the loan's interest rate. Instead, origination points are fees you pay to the lender in exchange for providing and processing the loan. Another name for origination points is "origination fees."
Both discount points and negative discount points are negotiable with the lender. In theory, you should be able to negotiate origination points, too. But your lender might not be willing to deal. So, if you apply for mortgages from different lenders, you might gain some leverage because one or more of them could be willing to be flexible to get your business.
To avoid harming your credit when applying for multiple mortgages, limit your applications to a short period. Some credit-scoring models consider several mortgage inquiries within 14 days as just one inquiry (they assume you're shopping around for the best deal), while others treat several inquiries as a single one if you make them within 45 days. Because you probably won't know what scoring model a particular lender will use now or when you apply for credit in the future, apply for different mortgages within 14 days to be safe.
Because purchasing discount points lowers your monthly payments, but costs you more when you take out the loan, a good place to begin thinking about whether the expense is worth it is to determine when you'll break even. You should also think about other factors before buying points on a mortgage, like how much they'll save you in the long run. Here are some issues to consider.
To figure out when you'll break even if you buy mortgage discount points, take the cost of the points and compare it to how much you'll save each month if you have a lower interest rate. After you break even, you'll start saving money.
The break-even point varies, depending on the size of the loan, the interest rate, and the term (the repayment period). Once you do the calculation, assuming you can afford the upfront cost of the points, think about whether you'll remain in the house and not refinance beyond the time when you break even. The longer you live in the property and make payments on the mortgage, the better off you'll be paying for points upfront to get a lower interest rate. But if you plan to sell or refinance your home within a couple of years (before you break even), you should probably opt for a loan with few or no points.
If you get an adjustable-rate mortgage, though, buying discount points might only reduce the interest rate only until the end of the initial fixed-rate period, not for the entire loan term. So, you generally need to make sure your break-even point happens before the fixed-rate period expires. Otherwise, it's usually not worth it to buy the points.
If you get a fixed-rate mortgage, the amount you pay each month to cover principal and interest on the loan remains steady for the entire loan, say 30 years. So, purchasing discount points to buy down the rate can save you thousands of dollars if you live in the home for a long time.
With an adjustable-rate mortgage, the lender might let you apply points to reduce the margin (the amount added to the rate index that determines your adjusted rate). So, you could potentially lower the interest rate for longer than just the introductory period.
Your credit history has a direct impact on the interest rate the lender will offer you. If you have low credit scores, the lender will likely give you a higher interest rate than what's available to those with good credit. So, if your credit scores aren't good, it might make financial sense to pay points for a lower rate after considering all other factors. Or you might consider taking steps to improve your credit before you apply for a mortgage loan.
By lowering your interest rate, which reduces your monthly mortgage payments, you free up some money each month that you can spend on other things. Also, if you buy discount points and itemize your taxes, you can fully deduct points associated with a home purchase mortgage. Refinanced mortgage points are also deductible (see below).
But also consider if you could take the money that you'd pay for points, like the $4,000 paid in the above examples, and use it or invest it somewhere else. For example, you could put that $4,000 towards making a larger down payment (see below).
Mortgage discount points are deductible for taxpayers who itemize. To get the deduction, you have to meet specific criteria, like your main home has to secure the loan. Generally, you must deduct the points over the life of the loan. But sometimes, you can deduct the points in the year you pay for them. But you can usually only deduct points paid on up to $750,000 of mortgage debt ($1,000,000 for mortgages originated before December 15, 2017). Home sellers sometimes agree to pay for points to provide an incentive to a potential buyer. The buyer can deduct points in this situation, too.
According to the IRS website, you can also deduct origination fees. But you can't deduct points paid for items that are usually listed separately on the settlement sheet, like appraisal fees, inspection fees, and attorney fees.
Rather than purchasing points, some borrowers make a larger down payment to reduce their monthly payment amount. Also, if you make a down payment large enough, you can usually avoid paying for private mortgage insurance (PMI). (In most cases, if you have a down payment of 20% or more, you don't have to pay PMI, which lowers the monthly payment amount.) The extra money you put towards the down payment might be money better spent than using your money on points.
In addition, putting more money down helps you build equity in the property faster. You could also decide to use the money to make extra payments on your loan and gain equity in your home quicker that way.
If you need help comparing loan terms and figuring out whether to pay points for a lower interest rate, the mortgage calculators at QuickenLoans, Zillow, Nolo, and other websites can help you in this process. These calculators usually allow you to enter the loan terms (rates, points, and fees) so you can compare various loans.
Homebuyers can find additional tools and resources on the Consumer Financial Protection Bureau's Buying a House website. Also, you can find a helpful chart showing when it makes sense to pay additional points for a lower interest rate, as well as useful information on buying a home, in Nolo's Essential Guide to Buying Your First Home, by Ann O'Connell, Ilona Bray, and Marcia Stewart.