What Is a Discount Mortgage and How Does It Work?
Learn how a discount mortgage can reduce your interest rate by paying upfront points. Evaluate this financing strategy for your home loan.
A discount mortgage is a home loan where the borrower pays an upfront fee, known as “points,” directly to the lender at closing. This payment reduces the mortgage’s interest rate over its repayment term. This lowers ongoing monthly payments and can decrease the total interest paid over the loan’s life.
Understanding Mortgage Points
Mortgage points are a form of prepaid interest borrowers can pay at closing. One mortgage point equals one percent of the total loan amount. For example, on a $300,000 mortgage, one point costs $3,000.
Points are categorized into two types: discount points and origination points. Discount points specifically lower the mortgage’s interest rate. By paying these upfront, a borrower “buys down” the interest rate, leading to smaller monthly payments. Origination points are fees paid to the lender for processing the loan and covering administrative costs; they do not reduce the interest rate. The focus of a discount mortgage is primarily on the use of discount points.
The exact interest rate reduction for each point paid varies among lenders and market conditions. It generally ranges from 0.125% to 0.250% per point. This mechanism allows borrowers to secure a more favorable interest rate than they would without paying points.
How Discount Mortgages Affect Loan Structure
A discount mortgage directly impacts the cash required at closing. The cost of discount points adds to other closing costs like appraisal fees, title insurance, and lender charges. This increases the total funds needed to finalize the home purchase or refinance. Borrowers need sufficient liquid assets to cover these elevated upfront expenses.
Despite the higher initial cost, a discount mortgage results in lower monthly payments. The reduced interest rate means less interest accrues each month on the principal balance. This provides relief to a borrower’s monthly budget.
The financial benefit of a discount mortgage becomes apparent over the loan’s full term. A lower interest rate means the total interest paid over 15 or 30 years is considerably less than a mortgage without points. For example, a $300,000 loan at 7.00% without points might result in $419,268 in total interest over 30 years. The same loan at 6.75% with points could lead to about $399,780 in total interest, a savings of nearly $20,000.
Calculating the Break-Even Point
The “break-even point” for a discount mortgage identifies how long it takes for savings from lower monthly payments to offset the initial cost of discount points. Reaching this point means the borrower has recouped their upfront investment in points.
To determine the break-even point, divide the total cost of discount points by the monthly savings from the lower interest rate. For example, if a borrower pays $3,000 for one discount point and saves $54.13 per month, the calculation is $3,000 divided by $54.13. This yields approximately 55.42 months, or roughly 4.62 years.
Consider a $300,000, 30-year fixed-rate mortgage. Without points, a 7.00% interest rate might lead to a monthly principal and interest payment of $1,995.91. If the borrower pays one point ($3,000) to reduce the rate to 6.75%, the monthly payment becomes $1,941.78. The monthly savings are $54.13. This means it would take approximately 55 months for the monthly savings to equal the initial $3,000 cost of the point.
The break-even point signifies the minimum duration a borrower needs to hold the mortgage to financially benefit from paying points. If the borrower plans to sell or refinance before reaching this period, they may not fully realize the financial advantage.
Financial Considerations for Borrowers
The anticipated length of time a borrower plans to keep their mortgage is a primary factor. Staying in a home significantly beyond the break-even point allows substantial long-term savings from paying points. However, if moving or refinancing within a few years, the upfront cost of points may not be recouped. Points typically become advantageous beyond three to five years.
Sufficient available cash for closing costs is important. Discount points add to the overall cash required at closing. Borrowers should assess liquid assets to comfortably cover these increased upfront expenses without straining financial reserves. Paying points should not jeopardize a borrower’s emergency fund or other financial goals.
The current interest rate environment influences buying down a rate. In higher interest rate periods, a small reduction from paying points leads to meaningful monthly savings. When rates are very low, the incremental benefit might be less pronounced relative to the cost of points.
Personal financial goals should align with a discount mortgage’s structure. For those prioritizing lower monthly expenses and long-term interest savings, paying points is suitable. Other borrowers might prefer to minimize upfront cash outlays, even with slightly higher monthly payments, to preserve liquidity.