How to Calculate Discount Points in Real Estate

Discount points are an upfront fee paid to a lender in a real estate mortgage transaction. This payment allows a borrower to secure a lower interest rate on their loan. Understanding how these points are calculated and their long-term implications is important for anyone considering a home loan, as they can significantly affect the overall cost of borrowing.

What Are Discount Points

Discount points are a form of prepaid interest that mortgage borrowers can purchase from lenders. They are distinct from other closing costs, such as origination fees, which cover the lender’s administrative expenses for processing the loan. The primary purpose of paying discount points is to reduce the interest rate on the mortgage over the life of the loan.

Each discount point typically equals one percent of the total loan amount. For instance, on a $200,000 mortgage, one point would cost $2,000. These points are paid at the loan closing, becoming part of the overall closing costs. By “buying down” the interest rate, borrowers aim to achieve lower monthly mortgage payments.

Calculating the Dollar Cost of Discount Points

Since one point typically represents one percent of the loan amount, the cost is determined by multiplying the loan amount by the percentage of points being paid. The formula for this calculation is: (Number of Points / 100) Loan Amount = Dollar Cost of Points. This amount is added to the borrower’s closing expenses.

For example, consider a homebuyer securing a $300,000 mortgage. If the lender offers the option to pay one discount point, the cost would be calculated as (1 / 100) $300,000, resulting in an upfront payment of $3,000. If a borrower is obtaining a $450,000 loan and opts to pay 1.5 discount points, the calculation would be (1.5 / 100) $450,000, equaling $6,750. Lenders may also offer the flexibility to purchase fractional points, allowing for more precise adjustments to the interest rate.

Evaluating the Long-Term Impact of Discount Points

Paying discount points can lead to significant financial implications over the loan’s duration. A lower interest rate translates directly into reduced monthly mortgage payments. This reduction also results in substantial savings on the total interest paid over the entire loan term.

To assess the value of paying points, borrowers should calculate their “breakeven point.” This is the period, measured in months, it takes for the accumulated monthly savings from the lower interest rate to offset the initial cost of the points. The breakeven point can be found by dividing the total dollar cost of the points by the monthly savings: Cost of Points / Monthly Savings = Months to Break Even. Once the breakeven point is reached, every subsequent monthly payment represents a net financial gain from having paid the points.

For instance, consider a $350,000, 30-year fixed-rate mortgage. With an interest rate of 7.00% and no points, the monthly payment might be $2,328. If paying one discount point costs $3,500 and reduces the rate to 6.75%, the monthly payment could drop to $2,270, creating a monthly savings of $58. Dividing the $3,500 cost by the $58 monthly savings yields a breakeven point of 60 months, or five years. Over the full 30-year term, the loan with points would result in lower total interest paid compared to the loan without points, assuming the borrower keeps the mortgage for its full duration.

Key Considerations for Using Discount Points

When deciding whether to pay for discount points, a primary consideration is the anticipated duration of the loan. Paying points is more advantageous if the borrower expects to keep the mortgage beyond the calculated breakeven point. If the home is sold or the loan is refinanced before reaching this point, the upfront cost of the points may not be fully recovered through interest savings.

Another important factor is the borrower’s financial liquidity, referring to the availability of cash for upfront costs. While discount points can lead to long-term savings, they require a significant payment at closing. Some borrowers may prefer to allocate this cash towards a larger down payment or other immediate needs. Current interest rate trends also play a role, as discount points can be appealing in periods of higher interest rates, mitigating the impact on monthly payments.