Discount Points

Discount Points (also known as 'mortgage points' or simply 'points') are a form of prepaid interest. Think of them as an upfront fee you can choose to pay your lender when taking out a loan—almost always a mortgage—in exchange for a lower interest rate for the entire loan term. It's a classic trade-off: pay more now to pay less later. One point typically costs 1% of the total loan amount. For example, on a $400,000 mortgage, one discount point would cost you $4,000 at closing. This isn't a fee you have to pay; it's an option. The core question for any savvy investor is whether this option represents good value. Is it a smart financial move to “buy down” your interest rate? The answer depends entirely on your personal circumstances and, most importantly, how long you plan to hold onto the loan.

Imagine you're offered a mortgage at a 6.5% interest rate. Your lender might present an option: “Pay us one discount point, and we'll lower your rate to 6.25%.” The exact rate reduction you get per point isn't standardized; it varies between lenders and changes with market conditions. Sometimes one point might buy you a 0.25% reduction, other times it might only be 0.125%. Let's walk through a simple scenario:

• Loan Amount: $300,000
• Option A (No Points): 7.0% interest rate. Monthly principal and interest payment = $1,996.
• Option B (1 Point): You pay 1% of $300,000, which is $3,000 upfront. Your new rate is 6.75%. Monthly principal and interest payment = $1,946.

By paying $3,000 extra at closing, you save $50 every month ($1,996 - $1,946). The real magic—or mistake—is determined by how long this continues.

From a value investing perspective, paying for discount points is a calculated bet on time. You are investing a lump sum ($3,000 in our example) to generate a future stream of savings ($50 per month). To see if it's a good investment, you need to calculate your break-even point.

The break-even point is the moment you've saved enough in monthly payments to cover the initial cost of the points. After this point, every subsequent payment is pure savings. The formula is simple: Cost of Points / Monthly Savings = Months to Break Even Using our example:

• $3,000 / $50 per month = 60 months (or 5 years)

This means you would need to keep the mortgage for at least five years to make paying for the point worthwhile. If you sell the house or refinance in year four, you will have lost money on the deal.

Before you decide to pay for points, ask yourself these critical questions:

• How long will I be in this home? This is the most important question. If you're in the military, have a job that requires frequent moves, or see this as a “starter home,” paying for points is likely a bad idea. If it's your “forever home,” they become much more attractive.
• Can I afford the upfront cost? Do you have the cash on hand? Paying for points might deplete savings you need for moving expenses, furniture, or an emergency fund. Don't stretch yourself thin. This is an opportunity cost calculation—could that cash be better used elsewhere, like in the stock market or for home improvements?
• What's my outlook on interest rates? If you believe interest rates are likely to fall significantly in the near future, you might want to refinance in a year or two anyway. In that case, paying for points today would be a waste.
• Are there tax benefits? In the United States, discount points on a mortgage for your primary residence are typically tax-deductible in the year you pay them. This can slightly reduce the net cost and shorten your break-even period. However, tax laws can be complex, so it's always best to consult with a qualified tax advisor.