Discount points are fees paid to a lender at the time that a mortgage loan is originated to lower the interest on the loan. One point usually lowers the interest by .125%. Paying points is not always a good strategy, but it can be, and it is something which people should consider during the process of applying for and processing a loan. Sometimes, a seller will agree to pay the discount points as part of the terms of sale, usually in exchange for a higher sale price.
One discount point is usually one percent of the loan. For example, someone taking out a $200,000 United States Dollars (USD) loan would have to pay $2,000 for one discount point. If the interest on the loan was 6.25% and the borrower wanted to bring it to 6%, it would be necessary to pay two points, or $4,000 USD, in order to lower the interest. Not all lenders offer discount points on their loans, and lenders usually limit the total amount of points a borrower is allowed to pay.
The obvious advantage to paying discount points is that they will reduce the amount of money paid over the life of the loan. At some point during the loan, the borrower will reach a break even point where the amount of money saved from the lowered interest is equal to the amount paid for discount points. After this point, the borrower starts to actively save money. If a borrower has money in the bank at the time of loan origination and wants to keep monthly payments low, paying discount points can be an excellent strategy.
However, if a borrower will not be keeping a house for very long, paying discount points may not make sense. For example, the break even point in a loan might be 10 years out. If the borrower knows that the house will probably be sold after five or six years, there is no reason to pay discount points, because the borrower will be taking a loss; more will have been paid in discount points than was saved in interest by the time the house sells.
When discount points are offered, it helps to sit down with a mortgage calculator. Borrowers can look at the amount that would be paid over the life of the loan at the standard interest rate and reduced interest rate, and determine how much money would be saved. Borrowers may also want to calculate the break even point if they are planning on selling the home rather than remaining in it or using it as a rental. Another thing to consider is whether or not the lender penalizes for early repayment. If a borrower plans to pay off a loan early, paying points may not make sense because the early payments may generate a comparable savings.