A discount point is a prepaid interest payment equal to 1% of the loan amount. Paying one point typically reduces the interest rate, with the rate reduction varying by lender, loan type, and current market conditions. The decision to buy points is a break-even calculation, not a question of good or bad.
How to Run the Break-Even Calculation
- ✦Cost of one point on a $400,000 loan: $4,000
- ✦If one point reduces the monthly payment by $50 per month, the break-even period is 80 months (6.7 years)
- ✦If the borrower sells or refinances before month 80, buying the point was a money-losing decision
- ✦If the borrower holds for 120 months, the net savings are $2,000 ($6,000 in payment savings minus the $4,000 cost)
- ✦The break-even ignores the time value of the $4,000, which slightly extends the true break-even
Rate Reduction Per Point Varies
The rate reduction per point is not fixed at 0.25%. It fluctuates based on current market conditions, lender pricing, loan size, and product type. In steep rate environments, the reduction per point may be lower. Lenders price the cost of lowering the rate based on what investors will pay for the higher-coupon vs. lower-coupon mortgage-backed security. Always pull the actual rate sheet to see the exact point-to-rate tradeoff for a given scenario before presenting options to the borrower.
Tax Treatment of Points
- ✦Points paid on a purchase mortgage for a primary residence are generally fully deductible in the year paid, subject to IRS requirements
- ✦Points paid on a refinance must be deducted ratably over the life of the loan, not all in year one
- ✦Seller-paid points are deductible by the buyer if they meet IRS requirements
- ✦Borrowers should confirm the tax treatment with their CPA, not rely on lender guidance
Points vs. Lender Credits
- ✦Points and lender credits are inverse: paying points reduces the rate, taking a credit increases the rate
- ✦Lender credits offset closing costs in exchange for a higher rate
- ✦For borrowers with limited cash or short planned hold periods, lender credits may be the better choice
- ✦The same break-even logic applies in reverse for lender credits
Aria can calculate the exact break-even period for any point cost and rate reduction combination and compare scenarios side by side. Ask at vicariointel.com.
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