Discount points are used to buy down an interest rate. One discount point is equivalent to 1% of the loan amount. Each discount point paid reduces the interest rate and monthly payment. A discount point is not always applied in 1% increments. A discount point can be applied in .125% increments (such as .5%, .75% etc.).
Discount points are paid in addition to all applicable closing costs and pre-paid items. The best way to understand a discount point is to view it as upfront interest. In reality, discount points are upfront interest paid to the investor in exchange for a lower interest rate.
Although discount points offer a lower interest rate and mortgage payment, it is not always beneficial to pay points. There are many factors to consider such as the length of time the property will be owned. In addition, you also want to think about the future expectation for interest rates.
As a rule of thumb, it is best to hold a mortgage for 3-5 years so that the cost of points can be recouped. After the recapture period, a borrower starts to realize the gains from the lower interest rate. There is often a misconception that holding a mortgage for 3-5 years applies only when selling a house. Clients have said, “I do plan to stay in my house for 10+ years. Therefore, paying points makes sense.”
In theory, the above statement makes sense. However, when deciding on points, it is important to consider the very real possibility of a refinance. If mortgage rates drop in the first 3-5 years, and a refinance occurs some of the cost of the points would be lost.
The average life of a mortgage in the United States is roughly 4-5 years. In many cases, it may only take a half percent reduction in interest rate for a beneficial refinance. Many clients refinance their mortgages every few years or more.
If there is a scenario where you are unsure if there is a benefit to paying points – please feel free to reach out to me directly for a review.