How Much Does It Cost to Buy Down Your Mortgage Rate?

To understand the true cost of a home loan, consider “buying down” your mortgage rate. This involves paying an upfront fee to the lender to secure a lower interest rate over the loan’s duration.

What Are Mortgage Discount Points

Mortgage discount points are an upfront fee paid to a mortgage lender at closing. This payment is made in exchange for a reduced interest rate on the loan for its entire term. Discount points act as prepaid interest, allowing a borrower to lower their monthly mortgage payments.

One “point” typically equals one percent of the total loan amount. For example, on a $300,000 mortgage, one point would cost $3,000. Borrowers can choose to buy whole points or fractions of a point.

How Discount Point Costs Are Calculated

Each point represents a percentage of the total loan amount. One discount point costs 1% of the principal mortgage balance. For a $250,000 mortgage, one point would cost $2,500.

The total cost increases proportionally with the number of points purchased. For instance, two points on a $250,000 loan would cost $5,000. Lenders may also allow the purchase of half-points, where 0.5 points on a $250,000 loan would cost $1,250. While one point reduces the interest rate by approximately 0.125% to 0.25%, this reduction can vary by lender and loan type. The cost of these points is added to the closing costs, paid when the mortgage is finalized.

Factors Affecting Discount Point Costs

The calculation for discount points (1 point equals 1% of the loan amount) remains consistent, but the number of points a lender offers to achieve a specific interest rate reduction can vary. Current market interest rates play a role; in a high-interest rate environment, lenders might offer more aggressive rate reductions. The specific pricing structure of each lender also influences the cost-to-reduction ratio.

The type of mortgage loan can also affect point pricing. For instance, discount points on a fixed-rate mortgage lower the rate for the entire loan term. On an adjustable-rate mortgage (ARM), they only reduce the initial interest rate before it becomes variable. A borrower’s creditworthiness can also affect the availability or pricing of points, as a stronger financial profile may lead to more favorable loan terms.

Evaluating the Financial Outcome of Paying Points

Assessing the financial impact of paying discount points involves comparing the upfront cost to the long-term interest savings. To determine potential savings, calculate the difference in monthly payments between a loan with points and one without. Then, multiply that monthly savings by the total number of payments over the loan’s life. For example, a $300,000, 30-year fixed-rate mortgage at 7.0% has a monthly payment of approximately $1,996. Paying one point ($3,000) reduces the rate to 6.75% with a payment of about $1,946, resulting in a monthly savings of $50. Over 30 years, this amounts to $18,000 in total interest savings.

To determine the “break-even point,” divide the upfront cost of the points by the monthly savings. Using the previous example, the $3,000 cost of one point divided by the $50 monthly savings results in 60 months, or five years. This signifies the period it takes for the accumulated monthly interest savings to offset the initial cost of the points. If a borrower plans to keep the mortgage for longer than this break-even period, paying points can result in net financial savings. Conversely, if the loan is paid off or refinanced before reaching the break-even point, the borrower may not fully recoup the upfront expense.

Tax Implications of Discount Points

Discount points paid to acquire a mortgage can be tax-deductible. For points paid on a loan to purchase or build a primary residence, the Internal Revenue Service (IRS) allows them to be fully deducted in the year they are paid, provided certain conditions are met. These conditions include the loan being secured by the main home, the points being customary for the area, and the borrower paying them directly, not from the loan proceeds. Even if the seller pays the points, they are treated as paid by the buyer for deduction purposes, though they may reduce the home’s cost basis.

When points are paid for refinancing a mortgage, the tax treatment differs. Points paid for a refinance must be deducted ratably over the life of the loan, rather than in the year they are paid. For example, points on a 30-year refinance would be deducted in equal amounts each year for 30 years. If the refinanced loan is later paid off early, any remaining unamortized points may be deductible in that final year. Consult IRS Publication 936, “Home Mortgage Interest Deduction,” for detailed guidance and a tax professional for specific tax situations.