Reader question: “I have heard it’s a good idea to use discount points to lower my mortgage rate, so I can save money over the long haul. At what point does it make sense to use this strategy? How do I calculate discount points on a mortgage loan? Or does the lender do it for me?”
Yes, the lender should provide you with a breakdown of how points will work for you, and how they will affect your monthly payments. You want to know three things: (1) How much will it reduce your monthly payments? (2) How much more will you have to pay at closing? And (3) how long will you have to keep the mortgage loan to make up for the extra amount paid at closing?
Your lender should do these calculations for you. But it helps to understand the math for yourself. So let’s talk about how to calculate discount points on a mortgage loan.
How to Calculate Discount Points on Your Home Mortgage Loan
You’ll need some information from the lender to perform this kind of calculation. Before you can calculate discount points, and when it makes sense to use them, you need to know…
- (A) How much the lender is going to charge you for each point.
- (B) How much they are willing to reduce your mortgage rate for each point (or fraction of a point) paid at closing.
Once you have these two pieces of the puzzle, you can calculate the length of time it will take to “break even” on your discount point strategy. So let’s talk about the (A) and (B) values mentioned above:
(A) — One point equals 1% of the loan amount. For instance, paying one discount point on a $300,000 mortgage loan means you’ll pay an extra $3,000 at closing (300,000 x .01 = 3,000). This part is standard across the industry. It does not vary.
(B) — How much will the lender reduce your rate for each point paid? This is something that varies from lender to lender. There is no industry-wide standard. So you need to get this information from the lender, before you can calculate discount points on your mortgage loan. Bob Walters, chief economist at Quicken Loans, says a general rule of thumb is that one point will reduce the rate by 1/4 to 3/8 on a 30-year fixed mortgage.
Once you have these two numbers, you can calculate the discount points on your loan. More specifically, you can figure out when this strategy will work to your advantage. The idea is to pay less in interest over the long-term, by paying extra money up front at the closing (points are basically a form of pre-paid interest). Mortgage professionals refer to this as your break-even point. The break-even point is when your accumulated monthly savings (from paying a lower rate) begin to exceed the amount you paid in points.
There are some handy calculators online that will help you do the actual math. Do a Google search for “mortgage points calculator,” and you’ll find several. But these are only estimates, because they don’t take into account the exact amount of the interest-rate reduction (which varies from lender to lender, as we discussed). But they can give you a pretty good ballpark estimate of the cost versus savings.
Tip: There’s an even easier way to calculate discount points on a mortgage loan. Have the lender do it for you! Ask them to present you with a few different scenarios on paper. One with no points. One with a single point paid. One with two points paid. This way, you can see how it will affect your monthly payments, and the total amount of interest paid over time. They can also show you where the break-even point lies for each point scenario.