Definition
Discount points are fees paid upfront to a lender at the time of initiating a loan. For each discount point purchased, normally 1% of the total loan amount, the borrower can lower the interest rate on their mortgage. These points are commonly used in various types of loans, including conventional, FHA, and VA loans.
Discount points are paid at the time of closing and can be either tax-deductible (as mortgage interest) or factored into the overall cost of the loan. Generally, purchasing discount points can make monthly payments more affordable over the life of the loan.
Examples
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Example 1: At the time of loan application, conventional mortgages have an interest rate of 5%. The borrower seeks a lower rate and decides to buy discount points. They take out a mortgage of $200,000 and buy 2 discount points to reduce their interest rate by 0.50%. With each point costing 1% of the loan amount, they pay 2% of $200,000, resulting in an additional upfront cost of $4,000.
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Example 2: During an FHA loan application, the maximum interest rate is 4.5%, but the borrower desires a lower rate. They decide to purchase 4 discount points. With a $150,000 loan, the cost of the points is $6,000 (4% of $150,000). This points agreement is compensated for the reduction in the FHA maximum rate to 4.5%.
Frequently Asked Questions
What are discount points?
- Discount points are fees paid directly to the lender at the closing to reduce the interest rate on a mortgage. One point typically equals 1% of the loan amount.
How do discount points affect the interest rate?
- Generally, for each discount point purchased, the interest rate on the mortgage can be reduced by about 0.25%. This resulting rate reduction can lower monthly mortgage payments.
Are discount points tax-deductible?
- Yes, discount points can often be deducted from taxable income as mortgage interest, especially if they are paid upfront at closing. Consult a tax professional for precise details.
How do I decide if buying discount points makes sense?
- If you plan to stay in your home for a long time, buying discount points can save money through lower interest payments over the life of the loan. Calculating the break-even point, where monthly savings offset the upfront cost, can help make this decision.
Can discount points be financed?
- Typically, discount points must be paid upfront at closing and are separate from the loan itself. However, lenders may include them in the closing costs and payments.
Related Terms
- Origination Fee: A fee charged by a lender for processing a new loan; often a percentage of the loan amount.
- Annual Percentage Rate (APR): A measure of the annual total cost of borrowing, including interest and fees, expressed as a percentage.
- Closing Costs: Expenses incurred in the finalization of a real estate transaction, usually including appraisal fees, title insurance, and attorney fees.
- Buy Down: An arrangement where the borrower pays money upfront to reduce the interest rate of the mortgage for a temporary or permanent basis.
- Amortization: The process of spreading out a loan into a series of fixed payments over time.
Online Resources
References
- “The Truth About Mortgage,” TheTruthAboutMortgage.com
- “Mortgage Discount Points Explained,” Investopedia
- U.S. Department of Veterans Affairs, Home Loan Program
Suggested Books for Further Studies
- “Mortgage Management for Dummies” by Eric Tyson
- “Your Score: An Insider’s Secrets for How to Rescue Your Credit Score” by Anthony Davenport
- “Real Estate Finance & Investments” by William Brueggeman and Jeffrey Fisher
- “Nolo’s Essential Guide to Buying Your First Home” by Ilona Bray
Real Estate Basics: Discount Points Fundamentals Quiz
### What is a discount point?
- [ ] A government subsidy for mortgage interest.
- [x] A fee paid to the lender to reduce the interest rate.
- [ ] A penalty charged for late payments.
- [ ] A type of origination fee.
> **Explanation:** A discount point is a fee paid directly to the lender at loan origination to reduce the interest rate on a mortgage.
### How much does one discount point typically cost?
- [ ] 0.5% of the loan amount.
- [x] 1% of the loan amount.
- [ ] 2% of the loan amount.
- [ ] It varies by lender.
> **Explanation:** One discount point typically costs 1% of the total loan amount.
### What is the effect of buying discount points on the interest rate?
- [x] It reduces the interest rate.
- [ ] It increases the interest just for the early term of the loan.
- [ ] It has no effect on the interest rate.
- [ ] It only reduces the initial principal.
> **Explanation:** Purchasing discount points reduces the interest rate on a mortgage, leading to lower monthly payments.
### Are discount points tax-deductible?
- [x] Yes, they often are deductible as mortgage interest.
- [ ] No, they are not deductible at all.
- [ ] Only in certain states.
- [ ] Only for FHA loans.
> **Explanation:** Discount points are often tax-deductible as mortgage interest if they are paid upfront at closing.
### Who can benefit the most from purchasing discount points?
- [x] Borrowers planning to stay in their home for a long time.
- [ ] Home flippers.
- [ ] Borrowers looking to refinance quickly.
- [ ] Everyone equally benefits.
> **Explanation:** Borrowers planning to stay in their home for a long time can benefit the most from purchasing discount points as the long-term interest rate savings will offset the upfront cost.
### How does a lender typically apply discount points?
- [ ] Adds them to the total loan balance.
- [ ] Uses them to offset origination fees.
- [x] Applies them to reduce the interest rate.
- [ ] Deducts them from monthly payments.
> **Explanation:** Lenders typically apply discount points to reduce the interest rate on a mortgage loan.
### What happens to monthly payments when you buy discount points?
- [x] Monthly payments decrease.
- [ ] Monthly payments increase.
- [ ] They stay the same.
- [ ] Monthly payments are postponed.
> **Explanation:** Buying discount points results in a reduced interest rate, leading to lower monthly mortgage payments.
### Do you always have the option to purchase discount points?
- [ ] Yes, it's a requirement.
- [ ] No, it's never an option.
- [x] Often, but not always.
- [ ] Only under certain loan programs.
> **Explanation:** Discount points are often available as an option, but not always. It's dependent on the loan type and lender policies.
### Is there a limit to the number of discount points you can buy?
- [x] Usually, yes.
- [ ] No, you can buy as many as you like.
- [ ] Only in government-sponsored loans.
- [ ] Only with fixed-rate mortgages.
> **Explanation:** Lenders usually set a limit on the number of discount points a borrower can purchase.
### What should you consider before buying discount points?
- [ ] The color of the property.
- [x] The length of time you plan to stay in the home.
- [ ] The type of landscaping in the community.
- [ ] The mortgage broker’s fees.
> **Explanation:** Before buying discount points, consider how long you plan to stay in the home to determine if the upfront cost is worth the long-term savings in interest payments.
