Mortgage Discount Points: Should You Actually Buy Them Down?

My uncle called me last month, worked up about something a loan officer had told him. The officer had offered him a chance to buy down his rate from 7.1 to 6.6 percent by paying two points at closing. Points are prepaid interest, essentially. Each point costs one percent of the loan amount. On his 300,000 loan, two points was 6,000 cash at closing in exchange for a lower monthly payment forever.

He asked me if it was a good deal. I told him it depends, which is the most unsatisfying answer in finance but also the only honest one. The math on buying points down is actually straightforward, and it comes down to one question. How long are you going to keep the loan?

What a point actually is

A discount point is one percent of the loan amount, paid upfront at closing, in exchange for a reduction in the interest rate for the entire term of the loan. Typically one point buys you a quarter percent reduction, sometimes a bit more or less depending on the lender and market conditions.

The idea is you prepay some interest at closing, and the lender gives you a lower rate going forward. The math works out to a long term break even.

Running the math

Take my uncle's example. 300,000 loan, 30 year term.

Without points: 7.1 percent, monthly P and I of 2,014. With two points, 6,000 cost: 6.6 percent, monthly P and I of 1,917.

Monthly savings: 97 dollars. Cost to buy down: 6,000. Break even: 6,000 divided by 97, equals 62 months, or just over five years.

If my uncle keeps the loan for five years and sells or refinances, he exactly recovers his points cost. If he keeps it longer, he comes out ahead. If he sells sooner, he loses money.

How long do people actually stay

Average mortgage life in the US is about seven years. Most people sell or refinance within that window. So if the break even is five years, half the time points pay off and half the time they do not.

But the average hides variation. If my uncle buys a starter house he plans to upgrade from in three years, points are a bad bet. If he is settling into his forever home at age fifty five, points are great.

When points make the most sense

Several situations favor buying points.

You are going to stay in the house for a long time. If you plan to keep this mortgage for ten plus years, almost any reasonable points package pays off.

Rates are high and expected to drop over time, but you need the lower payment now. Points can smooth cash flow during a stretched period.

You are buying a forever home where you plan to pay off the mortgage in full. Over 30 years, points savings compound hard.

You have extra cash on hand that is not earning much elsewhere. If your cash is sitting in a checking account earning two percent, redirecting 6,000 into points that save you 97 a month is a better return.

When points are a bad idea

You might sell or refinance soon. Any sale or refi before break even is a loss on the points.

You are stretched on closing costs. Do not deplete reserves to buy points. Having six months of savings matters more than a slightly lower rate.

You could invest the money elsewhere at a higher return. If you can put 6,000 into index funds averaging seven percent, you probably come out ahead over any typical mortgage life compared to a quarter point rate reduction.

Rates are falling and you expect to refinance soon. Buying points on a loan you plan to refinance in a year is just lighting money on fire.

Negative points, the opposite move

Some lenders offer negative points, called a lender credit. You take a slightly higher rate and the lender gives you cash at closing. This flips the math.

Example. On the same 300,000 loan, you could take 7.4 percent instead of 7.1 and get a 3,000 lender credit toward your closing costs. The payment is higher, but you save cash upfront.

This is a good move if you are tight on closing costs and plan to refinance within a few years anyway. You offset the higher rate by keeping cash in your pocket for a short time.

How points interact with APR

The APR, annual percentage rate, is the lender's attempt to show the total cost of the loan including points and fees. A loan with points has a lower interest rate but higher APR than a loan without points. The APR calculation assumes you keep the loan for the full term, which most people do not.

When comparing loan offers, look at both the interest rate and the APR. Also calculate the break even on points separately. The APR by itself can be misleading if your actual loan life does not match the assumption.

The lender's incentive

Here is the thing nobody tells you. Loan officers often make slightly more commission on loans with points, because the loan amount increases if points are financed, or the lender gets paid for the extra upfront cash. This is not always the case, but it is often enough that you should not take the officer's pitch at face value.

When your officer pushes points, ask them to show you the break even in months. If they cannot or will not do that math on the spot, you are talking to the wrong person.

Tax treatment of points

Points you pay on your primary residence mortgage are generally deductible in the year you buy the house, if you itemize. On a refinance, you have to spread the deduction over the life of the loan, which is much less valuable.

If the standard deduction is bigger than your itemized total, points provide no tax benefit, same as any other itemized deduction.

My uncle's call

I asked him three questions. How long do you plan to stay in this house, how is your cash position after down payment, and do you have other places to put the money.

He said he was buying his retirement house. He had enough cash to cover points plus six months of reserves. He had no plans to invest the extra money anywhere specific.

Buying points was a reasonable move for him. Over 25 years that he actually ends up keeping the loan, he will save roughly 30,000 after accounting for the 6,000 upfront cost. The absolute return is nothing crazy, but it beats leaving the money idle.

If you are not sure, do the break even math. Compare it to how long you realistically expect to keep the loan. Everything else is noise.