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Understanding mortgage discount points

Discount points in your mortgage could save you big. But what are they, exactly?

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Let's say that you would like to buy this house right over here, and after your down payment, you still need a $200,000 loan. So you go to your bank and you say, "Well, what are your interest rates on a $200,000 30-year fixed mortgage?" And the 30-year fixed just tell us that we're going to pay the same amount every month. Some of it is going to be interest; some of it is going to be principal, essentially paying down the mortgage, and after 30 years of that fixed payment, you will have paid down the entire $200,000.

And so your bank says, "Well, we have a couple of options for you. One option is that we'll just give you a 30-year fixed $200,000 mortgage at an interest rate of 6.0%, in which case your monthly payment is going to be $1,199.10." You say, "Okay, well that's interesting. What's the other option?" The other option that the bank tells you is "Well, we have these things called points, mortgage points," and if you want to pay mortgage points, in particular discount points, we're not going to talk about origination points in this video, but if you want to pay discount points, what discount points do is it allows you to pay down, essentially it allows you to put some money upfront in exchange for getting a lower interest rate.

So the way the discount points typically work is for every 1.0% of the loan value that you put upfront, you get 0.25 point discount on your interest rate, 0.25 point discount for every 1.0% that you put up, and in this case, your mortgage broker says, and you can essentially buy as many as three points, as three discount points, so for example you could pay 3.0% of the loan amount upfront, and in exchange for that, you're going to get 0.75, I'm just multiplying everything by three, you can get a 0.75% discount on your interest rate.

And you say, "Well, okay, if I were to do this, if I would pay 3.0% upfront, 3.0% of $200,000 is going to be $6,000." So if I pay $6,000 upfront, what's going to be my monthly payment? Well, then you're going to be paying a 5.25% instead of a 6.0%. We're taking a 0.75% discount. So you're going to pay a 5.25% interest rate, in which case your monthly payment is going to be $1,104.40, and so you say, "Okay, let me make sense of all of this."

I can either put no money upfront, so there's no money upfront in terms of discount points. You'll probably have to pay mortgage closing costs and other things, but if we're just talking about discount points right over here, but no discount points. I have to pay $1,199.10 every month, or if I put $6,000 upfront right now, I'm going to have a lower payment, and let's see, how much is this lower by? This is lower by $94.70, so pay $94.70 less per month. So which one does it actually make more sense to do?

Well, as you could imagine, in most scenarios in finance, it depends. It depends on how long you plan on paying this mortgage. Well, you're probably saying, "Well, look, this is a 30-year fixed mortgage. Don't I plan on paying it for 30 years?" Well, maybe, you could. You could decide that you want to live in this house for 30 years, and you just pay one of these amounts for 30 years, and then you own your house outright, but statistics show us that most people don’t keep their house for 30 years. Many people sell them a lot sooner than that or they want to move into a different house, and so it really depends on how quickly you might decide to sell this house, or maybe you're not even going to sell this house, you might want to refinance your mortgage at some point if interest rates go down. So how could we think about it?

Well one way is, if you pay the $6,000 upfront, how much will it take you if you were getting this much kind of less in your monthly payment, how long will it take you to make up this $6,000? Well, let's get our calculator out to think about it. So let's take 6,000, which is what you would have to pay upfront, and let's divide it so every month you're paying 94.70 less, so in very rough terms – I'm not discounting, I'm not present valuing all of these, but, just to get a rough sense – in about 63 or 64 months, so approximately 63 to 64 months, you're going to essentially get this $6,000 back.

So one way to think about it is, if you plan on refinancing 63 to 64 months, so it's a little over five years, so if you think you're going to refinance or sell your house in less than five years, it probably doesn't make sense to pay for these points right over here, these discount points, because you're not going to have a chance to make it all back; but if you think you're going to keep this loan for 6 years, 7 years, 8 years, 10 years, definitely 30 years, then it could very well make sense to pay these points, and there's other things that you have to keep in mind.

A lot of times when people are buying a house, they're getting stretched a little thin, so even if you do think you're going to keep the loan for 10 years, 15 years, 20 years, 30 years, you might be a little cash strapped to put this amount upfront. So these are all the things that you kind of have to weigh before you, I guess, pay down these discount points. But the general idea, if you have the money, if you plan on keeping the loan for a long time, in this scenario, 6, 7, 10, 15, 30 years, then it at least makes economic sense to pay for the points.

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