How to Calculate Discount Points and Your Breakeven Point

When securing a mortgage or refinancing an existing home loan, borrowers often encounter various fees and charges. Among these, discount points represent an upfront fee paid to a lender at the time of closing. This payment is directly related to the interest rate offered on the loan, providing a mechanism for borrowers to potentially lower their long-term borrowing costs. Understanding how these points function is important for anyone navigating the mortgage process.

What Discount Points Represent

Discount points are a form of prepaid interest on a mortgage loan. They allow a borrower to reduce the interest rate for the loan’s entire term. One point equals one percent of the total loan amount. For example, on a $300,000 mortgage, one point costs $3,000.

Lenders offer discount points to attract borrowers, as paying these upfront fees can lower the monthly payment. This mechanism allows lenders to secure immediate interest income while offering a more competitive interest rate over the loan’s life. Discount points differ from other closing costs, such as origination or appraisal fees. While origination fees cover administrative processing and are generally not tax-deductible, discount points are a direct trade-off for a lower interest rate and may offer tax benefits.

Determining the Cost of Discount Points

The cost of discount points is straightforward, as each point represents one percent of the total mortgage amount. The formula is simply the number of points multiplied by the loan amount. For instance, if a borrower seeks a $400,000 mortgage and pays one discount point, the cost is $4,000 ($400,000 x 0.01). If the borrower chooses to pay 1.5 points on that same $400,000 loan, the cost increases to $6,000 ($400,000 x 0.015). Lenders typically allow borrowers to purchase whole, half, or fractional points, providing flexibility in upfront cost for a lower rate.

Assessing the Financial Impact of Discount Points

Paying discount points influences the interest rate on a mortgage. While the exact reduction varies by lender and market conditions, one discount point typically lowers the interest rate by approximately 0.25 percentage points. For example, if a loan initially has a 6.00% interest rate, paying one point might reduce it to 5.75%. This reduction can lead to notable savings on monthly mortgage payments and over the loan’s lifetime.

The long-term financial benefit of paying points hinges on how long a borrower keeps the mortgage. To evaluate this, calculate the “breakeven point,” the duration it takes for savings from lower monthly payments to offset the initial cost of the points. The breakeven point is found by dividing the total cost of the discount points by the monthly savings from the reduced interest rate. For example, if points cost $3,000 and the monthly payment decreases by $50, the breakeven point is 60 months, or five years ($3,000 / $50 = 60).

Discount points paid for a mortgage to purchase or build a main home can often be tax-deductible in the year paid, provided certain IRS criteria are met. These criteria include points being customary for the area, the loan secured by the home, and points calculated as a percentage of the principal loan amount. For refinances or loans on second homes, points are generally deducted ratably over the life of the loan. Borrowers should consult a tax professional to understand specific rules and mortgage interest deduction limits.