What are discount points?

What are discount points?
Discount points enable you to lower your loan’s interest rate. They are basically prepaid interest, with each point equaling 1% of the total loan amount. By and large, when you pay a point on a 30 year mortgage, you can lower your interest rate by 1/8 (or.125) of a percentage point. When comparing loan rates, ask lenders for an interest rate with 0 points and then see how much the rate decreases with each point paid. Discount points are a good idea if you plan to stay in your home for some time since they will lower your monthly loan payment. Points are tax deductible when purchasing a home and sometimes you can negotiate with the seller to pay for some of them.

Many borrowers are required to pay discount points in order to qualify for their mortgage, because paying points reduces the monthly payment, which thereby reduces the Debt To Income ratio you've heard so much about. This is a measure of your monthly housing expenses, including the mortgages payment and other recurring monthly expenses divided by your monthly income. If your mortgage payment is too high, you may not be able to qualify for the loan because your Debt to Income ratio will be too high for the bank to feel confident in your ability to repay the mortgage. Paying tax deductible discount points can sometimes lowerthe payment enough to allow you to qualify for the mortgage.

It is important to remember that, even though you may have paid discount points, when rates go down do not hesitate to refinance.

When deciding whether or not to pay discount points it's important to find not only the difference in payment between the rate with no discount points and 1 discount point but to figure out how long it will take you to recoup the cost of the discount point.

For example if you qualify for a fixed rate of 7% and 1 discount point would provide you with a fixed rate of 6.75% on a $150,000 loan the difference in payment would be $25.05. However the cost of the discount point would be $1,5000. As such, paying the discount point would only be in your benefit if you don't sell or refinance prior to 5 years as you wouldn't realize a savings until payment #60.

Typically, it is advantageous to pay discount points if you plan on hold the property for a long period. Remember, discount points are tax deductable over the life of the loan.

As a general guide on Fannie Mae financing, each 1/8% in rate can be bought down with a 1/2 pt in discount fee. There are often variances in this spread, but this has been the general rule for some time.

» DISCLAIMER: The information contained in this article on 'What are discount points?' is a collection of contributions by licensed mortgage professionals and is not the opinion of Broker Outpost LLC. Always consult a licensed professional before applying for a mortgage.