How to Calculate Discount Points on a Mortgage

Mortgage discount points are a form of prepaid interest paid to a lender. Their primary purpose is to secure a lower interest rate on a home loan. This can lead to significant savings over the loan’s duration by decreasing monthly mortgage payments and reducing the total interest expense. Borrowers often consider this option to lower their overall loan cost.

Understanding Discount Points

Discount points are an upfront fee paid to a mortgage lender for a reduced interest rate. Each point costs 1% of the total loan amount. For example, on a $300,000 mortgage, one discount point costs $3,000. This payment allows a borrower to lower their interest rate.

The reduction in interest rate for each point often falls within 0.125% to 0.25%. Lenders set their own terms for how much each point reduces the interest rate and may limit the number of points a borrower can purchase. These payments are made at loan closing and become part of the overall closing costs. While discount points primarily benefit fixed-rate mortgages, for adjustable-rate mortgages (ARMs), they typically only reduce the interest rate during the initial fixed-rate period.

Calculating the Cost of Discount Points

The cost of discount points is calculated as a percentage of the total loan amount. One discount point equals 1% of the principal loan amount. For instance, a borrower taking out a $250,000 mortgage who pays one discount point would incur an upfront cost of $2,500.

To calculate the cost, multiply the loan amount by the percentage of points. For example, 1.5 discount points on a $400,000 mortgage would cost $6,000 ($400,000 x 0.015). This upfront payment is made at the time of closing and is distinct from other closing costs, as its purpose is to reduce the interest rate.

Calculating Interest Savings from Discount Points

To calculate interest savings from discount points, compare the total interest paid over the life of a loan with points versus a loan without points. This involves determining the monthly payment for each scenario using a mortgage amortization formula. For example, consider a $300,000, 30-year fixed-rate mortgage. Without points, the interest rate might be 7.0%, while with one discount point paid, the rate could drop to 6.75%.

First, calculate the monthly payment for each loan. The difference between these two monthly payments represents the immediate monthly savings. To find the total interest paid over the life of each loan, multiply the monthly payment by the total number of payments (e.g., 360 for a 30-year loan) and then subtract the original loan principal. The difference in total interest paid between the higher-rate loan and the lower-rate loan reveals the overall interest savings.

For instance, if the 7.0% loan has a monthly payment of approximately $1,995.91, resulting in $418,527.60 in total interest over 30 years. If the 6.75% loan has a monthly payment of approximately $1,946.04, resulting in $400,574.40 in total interest. The interest savings would be $17,953.20. This saving over the loan term highlights the financial benefit of paying points, assuming the borrower keeps the loan for its full duration.

Determining the Breakeven Point

The breakeven point is the duration it takes for interest savings from a lower rate to offset the upfront cost of discount points. To calculate this, divide the total cost of the discount points by the monthly savings from the reduced interest rate. For example, if one discount point on a $300,000 mortgage costs $3,000 and reduces the monthly payment by $49.87, the calculation is $3,000 divided by $49.87.

This yields approximately 60 months, or 5 years. This means that after about 5 years, the cumulative savings will have recouped the initial $3,000 spent. If a borrower anticipates staying in the home or keeping the mortgage longer than this breakeven point, paying for discount points is financially advantageous. If they expect to sell or refinance sooner, paying points may not be cost-effective.

Impact of Discount Points on Your APR

The Annual Percentage Rate (APR) measures the total cost of a mortgage loan, including the interest rate and other charges like discount points. Unlike the nominal interest rate, which only reflects the cost of borrowing the principal, the APR presents the true annual cost of the loan as a percentage of the loan amount. When discount points are paid, they are factored into the APR calculation, increasing this rate.

For example, a loan with a stated interest rate of 6.75% might have a 6.85% APR if discount points are paid. This difference occurs because the upfront cost of the points is amortized over the loan term and added to the interest charges for APR calculation. Understanding the APR is important for comparing different loan offers. A loan with a lower interest rate might not be the cheaper option if it requires many discount points, resulting in a higher APR.