Buying Down Your Rate: Discount Points Explained
When you are locking in a mortgage, lenders will often offer you a menu of different interest rates. You aren't just stuck with one "market rate." Instead, you have the option to literally pay cash upfront at the closing table to artificially lower your interest rate for the life of the loan.
This mechanism is called buying Discount Points (or simply "points").
What Exactly is a "Point"?
In mortgage terminology, one point is equal to 1% of your total loan amount.
- If you are borrowing $1,000, buying one point will cost you exactly $1,000 in cash upfront.
- If you are borrowing $1,000, buying two points will cost you exactly $1,000 upfront.
In exchange for handing the bank this lump sum of cash, they will permanently reduce your interest rate. Typically, purchasing one point lowers your interest rate by 0.25% (a quarter of a percent). So, if the par market rate is 6.5%, paying 1 point ($1,000 on a $1k loan) would lock your rate at 6.25% for the next 30 years.
The Mathematical Gamble
Buying points is essentially a massive gamble on how long you intend to keep the mortgage. You are trading guaranteed cash today for slow, methodical savings tomorrow. To win this gamble, you must calculate the Break-Even Point.
The Break-Even Analysis
- The Cost: You pay $1,000 upfront to drop your rate from 6.5% to 6.25%.
- The Savings: This lower rate reduces your monthly payment by $1 a month.
- The Math:
Break-Even (Months) = Cost of Discount Points / Monthly Interest Savings
It will take exactly 5 years of $1 monthly savings just to recoup your original $1,000 investment.
- If you sell the house or refinance the loan in Year 3, you lose money. You paid $1,000 but only saved $1,800.
- If you keep the loan for 15 years, it was a brilliant investment. You paid $1,000 and saved $1,000.
When Should You Avoid Points?
You should absolutely refuse to buy discount points if:
- You might move soon: If there is any chance you sell the house within 3-5 years, keep your cash.
- You plan to refinance: If current rates are high and you intend to refinance in a few years when rates drop, buying points today is throwing money away. The points only benefit you if you keep this specific loan.
- Cash is tight: If buying points completely drains your emergency fund and leaves you house-poor, the $1 a month in savings is absolutely not worth the immediate financial risk.