A discount point, or “point” is a lender charge used in conjunction with an interest rate.  It’s sometimes called a “discount” point because it’s used to discount the interest rate on a prospective mortgage loan.  But how much are points and are they required?

A point is equal to one percent of the loan amount.  If your loan amount is $250,000 then one point would equal $2,500.  Discount points are typically tax deductible for those that itemize primarily because they’re a form of prepaid interest.  You’re giving the lender $2,500 up front in exchange for the lower interest rate.

Points are always an option, they’re not mandatory on every loan.  You should evaluate the option of paying points carefully because the math may not work out in your favor.

When you pay one point, you’re “buying down” or lowering your interest rate by about ¼ percent.  If your lender is offering you 5.25 percent with no points they should also have available 5.00 percent with one point.  If you want, you can lower your rate even more by paying still more points.  So should you pay points to lower your rate? 

It’s a “point” often pondered but with a little math the answer will be obvious.

Have your loan officer calculate your monthly payment on a rate with no points, with one point and with two points.  Let’s use the $250,000 loan amount as an example and see what happens.

With a 30-year fixed rate loan at 5.25 percent, the principal and interest payment works out to $1,380.  Let’s say 5.25 percent is available with no points at all.  Now reduce your interest rate by ¼ percent, to 5.00 percent, and the monthly payment comes to $1,342 per month.  Pay two points and your payment falls all the way to $1,304!  Yet don’t forget the lower payments cost you some money.  One point is $2,500 and two points is $5,000.

Take the difference in monthly payments then divide that into the point(s) you paid.  The result is the number of months it will take to “recover” the amount paid in points.  The difference between 5.25 percent and 5.00 percent is $38 per month.  Divide that amount into the $2,500 and the result is 66 months.  That’s over five years.  The difference between 5.25 percent and 4.75 percent is $76.  Now divide that into $5,000 and the answer is again, 66 months.

That’s a long time in my book.  I realize it’s a tax deduction but could you use those funds to either pay your principal down or pay other bills?  I think so.  But the decision is ultimately yours, it’s just the math never seems to work out. 

I think you see my point.