An Examination of Discount Points

Discount points are used to increase the lender's financial yield on a mortgage loan. They actually bridge the gap financial between interest rates, allowing the lender to make the loan at a lower rate. For example, any lender that has a choice of making a loan at 7 percent or at 7½ percent interest will obviously choose to lend at the higher rate. This, however, may not allow the lender to remain competitive in the marketplace. Points, therefore, allow lenders to lower rates while maintaining their profit margins. One point is equal to 1 percent of the face value of a loan. So, for a $150,000 mortgage loan, one point would be equal to $1,500.

While the value of points can vary depending on current financial markets, most lenders generally consider that it takes roughly four to six points to lower a loan's interest rate by 1 percent. Here's a quick example: a lender quotes that it will take two points (or 2 percent) to lower an 8 percent interest rate to 7½ percent on a $100,000 loan. The calculation is straightforward -- $100,000 multiplied by 2 points (or 2%) would come to $2,000 – which would be payable in cash at closing to bridge the lender's financial gap in interest by one-half percent.

So, how does the borrower determine how many points he or she should pay for a mortgage? If the lender offers an option of paying points for a certain rate of interest, the borrower must consider several important factors. One of the main issues to regard is the length of time that the borrower will own the property and keep the mortgage. At some point in time during the loan, the points will have paid for themselves and begin to save the homebuyer money. This is called the "break-even point" and can be calculated as follows: find the difference in the monthly payment amounts of the loan with and without points being paid, then divide the amount paid in points by that monthly payment difference (which is the amount saved every month by using the lower monthly payment). The result is the break-even point for holding the property. Here's a simplified example:

Buyer A wants a $90,000 mortgage for thirty years. The lender gives him two options: he can pay 7½ percent interest with zero points for a payment of $629.30 per month, or he can get a 7 percent loan with two points and monthly payments of $598.78.

The difference between the two mortgage payments is $30.52 ($629.30 - $598.78 = $30.52). The amount paid in points is $1,800 ($90,000 x 2% = $1,800). The break-even point is calculated by dividing the amount paid in points ($1,800) by the monthly savings of the lower mortgage payment ($30.52). It would therefore take Buyer A almost fifty-nine months (nearly five years) to break even and begin realizing savings from paying the two points up front. Of course, if he doesn't plan to keep the house or the loan for that length of time, it would not make financial sense to pay the points to obtain the lower interest rate. Remember, however, that this example is a relatively simplistic analysis, and other important factors haven't been taken into account, such as the time-value of money (including the lost financial opportunity of not investing that money elsewhere), the long-term savings of the lower interest rate, or other tax ramifications.

Lenders determine points primarily based on the price that they have to pay for the funds, the type of loan involved, and other lender competition in the marketplace. Although negotiation of points may be possible with the lender if the borrower is strong and competition keen, negotiation of payment of points between homebuyer and seller is a normal occurrence.

For residential real estate purchases, discount points are tax deductible in the year in which they're paid. However, according to the IRS, they must not exceed the amount of points generally charged in the local area in order to be deducted. Points paid for refinancing are handled differently; they must be deducted over the life of the loan. For example, if a borrower paid $1,800 in points when refinancing to obtain a 30-year loan with a lower interest rate, he or she could only deduct $5 for each of the next 360 months, or $60 per tax year. But the IRS does allow refinance points to be deducted in the year that they're paid if part of the refinance money is used to pay for improvements to the home and the taxpayer meets other requirements. Under those circumstances the points associated with the improvements may be fully deducted in that same year.