Discount Points: Does It Make Sense For You?

Juggling the financial burdens of everyday life while paying off a mortgage can be very difficult. There are plenty of budgetary unknowns to try to anticipate over a 10 or 25 year period (or longer), so it helps to have as much information as possible. One of the financial options you should inform yourself about and consider is purchasing discount points to lower the interest rate on your loan.

Discount fees are essentially fees you pay to your financial lender at the time of closing to secure a lower interest rate on your home loan. Each ‘discount point' costs the home buyer one percent of the loan amount and generally lowers the interest rate on the buyer's 30 year loan by 0.125 percent. So if a buyer with a home financing loan of $200,000 with an eight percent interest rate pays an extra $2,000 at the time of closing (two discount points worth), he or she can lower his or her interest rate to 7.75 percent. The discount points system lowers the interest rate because the lender is able to collect its money earlier rather than spread out over the course of the loan period.

Buying discount points to lower your loan interest rate may seem like a good idea, and it is for many home buyers, but not all. Depending on the specifics of your loan and your financial situation, buying discount points to lower your interest may save you money or it may not. In some cases, the savings may be so inconsequential that buying the discount points may not be worth the extra financial burden or cash flow stress that it causes.

So how do you know whether or not buying discount points is a worthwhile option for you and your financial situation? The length of time you intend to keep the loan is a key factor to finding the answer to that question. Once you have that information, in an ideal world, there would be no unexpected life expenses and the answer would be revealed with a few simple calculations. Unfortunately, life often dishes out the unexpected and sometimes that costs a lot of money, so it's impossible to have a fool-proof plan. The good news is the calculations are still fairly straight-forward, and barring any major catastrophes, they can give you a good idea about whether or not it makes sense for you to take advantage of discount points to reduce your loan interest rate.

Begin by using an online mortgage calculator to determine what your monthly payment would be at the interest rate if you do not purchase discount points from your lender. Then do the same calculation to find out how much your month payment would be if you do decide to purchase discount points. Subtract the first amount from the second to figure out the difference you could save each month and then divide the amount it would cost to buy discount points at closing by the monthly amount saved. The resulting figure represents the number of additional months you would have to keep the loan to break even or recover the cost incurred by using points. If you do not intend to stay in the house long enough to recover the cost, you may not want to buy the discount points.

By using a amortization schedule (also available online or from your financial institution) to compare the financial impact of both loan scenarios, you may discover that the reduced-rate loan has a nominally lower principal balance at the end of the discount point cost recoup period, which may also play into your decision.

Finally, you may want to consider the tax advantages presented by purchasing discount points from your lender. The cost of real estate discount points is deductible in the year in which it is paid. Of particular note, buyers are able to deduct the cost of discount points even if the seller actually pays for them.

While there are pros and cons to buying discount points from your home financing lender, your final decision must be based on your specific needs and financial situation. Speak to your financial advisor or lending institution to decide on the best course of action to ensure you can pay off your loan in the best possible way.