How Do Discount Points Work?

“Owning a home is a keystone of wealth — both financial affluence and emotional security.” -Suze Orman

When you are a homebuyer or homeowner looking to finance your mortgage, you might hear from lenders that you can pay extra upfront costs to buy discount points in exchange for a lower interest rate. In theory, this sounds like a smart move because your monthly mortgage payments would be lower, and you can save some money in the long run. However, what if interest rates are expected to fall? Does it still make sense to pay for discount points? In this article I want us to explore why it might not be the best financial decision and provide 3 examples of why paying for discount points can be a sunk cost depending on the climate of the market.

“A formal education will make you a living; self-education will make you a fortune.” -Jim Rohn

Firstly, let’s define what discount points are and how they work. Discount points are a form of prepaid interest where you pay extra fees to lower your interest rate. One discount point typically costs 1% of your total loan amount, and it can lower your interest rate by around 0.125–0.25%. For instance, if you have a $200,000 mortgage and your interest rate is 6%, paying one discount point ($2,000) can lower your interest rate to 5.75%. This can result in a lower monthly payment and potentially save you money over the life of the loan if you plan to stay in your home for a long time.

However, here’s the catch. If you pay for discount points and then end up refinancing your mortgage within a year or two, you will essentially lose money because you won’t have enough time to recoup the upfront costs. This is especially true when interest rates are expected to fall, which means could have gotten a lower rate in the future when you refinance without having to pay for discount points the first time around.

Let’s take a look at an example. Suppose you pay two discount points ($4,000 based on the $200,000 loan amount) upfront to lower your interest rate from 6% to 5.5%. After a year, you decide to refinance your mortgage because interest rates have dropped, and you can get a new rate of 4.5%. In this scenario, you would have lost nearly $4,000 because you didn’t stay in your home long enough to recoup the discount points’ upfront costs.

“Patience and diligence, like faith, remove mountains.” -William Penn

Secondly, paying for discount points might not be worth it for some homeowners, even if they do stay in their homes for a long time. This is because the savings from the lower interest rate might not be significant enough to justify the upfront costs. Depending on each persons loan amount, down payment, and interest rate, it can take three to seven years to recoup the upfront costs of discount points, depending on how long you stay in your home and how much you paid for discount points. If you plan to sell your home before recouping the costs, paying for discount points could be a financial loss that you will never receive the benefits from.

“A man who does not plan long ahead will find trouble right at his door.” -Confucius

Now that you understand a little bit more on how discount points work, it’s equally important to note that interest rates are hard to predict, and we can’t determine with certainty if they will rise or fall. There are numerous factors (inflation, employment, GDP, etc.) that directly impact the future projection of where rates are supposed to go, but as the last few years have shown us, life can be unpredictable. The desire is that the more educated you are on how interest rates and discount points work, the more informed of a decision you can make to ensure you are using your money wisely.

So with all of that being said, paying for discount points can be a useful option if you stay in the same property for an extended period. But, it might not be the right decision if interest rates are projected to decline, which is what is expected in the next 6–18 months based on inflation rates and other economic factors. If you’re uncertain about how long you are staying in your home and if your lender is stating that refinancing in the near future is a high possibility, it’s better to not pay for discount points to avoid a sunk financial cost. If the interest rates decline rapidly in the next 6 months as many are speculating, then paying for discount points won’t benefit you near as much compared to if we were in a climate of stable or increasing rates. Like all things in life, you must make an educated decision after considering your personal finance situation, interest rates and projected living arrangements. Always do detailed research and consult a reputable financial advisor or mortgage advisor before making any financial commitment.

This is not financial advice. For educational purposes only. Before making any financial decisions, consult with a professional.