Discount points, are points that you can buy when closing on a real estate transaction to lessen the interest on your mortgage. These points reduce the overall interest rate you pay on the mortgage, with a fixed reduction for every point you buy. Unfortunately, more often than not, the cost of buying the discount points exceeds any savings from the reduced interest rate on your mortgage.
The points costs one percent of the total amount of the loan. For example, discount points on a mortgage valued at $1,000,000 (one million) would cost $10,000 each. Typically on a 30-year loan, each discount point purchased would reduce the interest rate by 0.125 percent. Enabling you to reduce your interest rate to whatever amount you consider worthwhile or that you can afford.
This works out for the lender because he is receiving the interest in a lump sum right at the beginning of the loan. The lump sums paid as part of the purchase of points will far exceed the value of the interest component over the period of the mortgage.
When deciding to buy points, there are several factors that determine if it is worthwhile or not but it mostly depends on reasons that are specific to you and your loan amount. To explain, let’s calculate the savings on a 30-year loan for $100,000. At a 7.5% interest rate, the monthly payment would amount to $699.21 a month, with the monthly payment dropping to $690.68 when buying a single point at $1,000. That is a saving of $8.53 a month on that single point. Considering that saving cost $1,000, it would take 117 months (almost ten years) to recover the cost of that single point.
If you plan to move or buy a new home within that time, buying points to reduce the rate might not be the best course of action. Carefully consider the economic benefits and any plans you might have before making a decision.