MORTGAGE 101: What are Discount Points?

Smart consumers should avoid paying these expensive fees

For many homebuyers, one of the biggest mysteries of mortgage lending is its strange terminology. Despite the efforts of the Consumer Finance Protection Bureau to simplify the mortgage disclosure process in 2017, even the most knowledgeable of homebuyers can get a little confused when trying to understand the various closing costs involved in a home purchase loan or refinance loan. One of the most costly errors that many homebuyers commit is paying for expensive fees known as ‘discount points’ for their loan.

The term ‘discount points’ seems innocent enough. After all, who doesn’t want to take advantage of something with the word ‘discount’ in it? Doesn’t that mean I’m actually saving money?

Well, far from it.

Simply put, discount points are fees paid to a lender in exchange for what should be a lower interest rate. In the mortgage lending world, one discount point is equal to 1% of your loan amount. For example, if you borrow $200,000 to buy a house and the lender charges you one discount point, you’re going to pay an additional $2,000 in closing costs. Does that sound like you’re saving money? Not so much.

When you shop for a mortgage lender, you’ll find they offer a number of different interest rates for each type of loan. For example, a lender can probably offer you several different interest rates for a 30-year fixed rate loan. Logically, the lower the interest rate for a given loan, the less that loan is worth to the lender. Consequently, the lender will charge you discount points to offset the difference between the interest rates. This is known as “buying down the interest rate”.

At first glance, a 4.50% interest rate for a 30-year loan might look pretty good when compared to a 4.75% rate. But since the lender might charge you thousands of dollars in discount points for the 4.50% rate, the smarter option in most cases is to choose the 4.75% interest rate and save yourself thousands of dollars in closing costs.

In this age of shopping on the internet, many homebuyers mistakenly fall into the trap of focusing entirely on the interest rate when they shop for a mortgage while ignoring the closing costs they’re going to pay. Unfortunately, greedy banks and lenders will capitalize on this tendency and charge discount points to their customers regardless. Many customers will then finance (or add) thousands of dollars in closing costs into their loan amount because they mistakenly believe they’re getting a superior deal. But they’re not.

The lowest rate does not always equal the best loan

Smart homebuyers focus on the closing costs as well as their interest rate when shopping for a loan. Avoid obsessing over the almighty interest rate. Instead, compare the closing costs of two loans versus the difference between the two payments. To use the $200,000 example cited above, would you pay an extra $2,000 of your hard-earned money just to have a monthly payment that’s a mere $20 lower? Don’t do it!

All of which raises another important question–do I have to pay discount points for a mortgage? The answer is absolutely not. Homebuyers should minimize their closing costs as much as possible and work with a lender who can walk them through the least expensive options. Don’t fall into the marketing trap of picking an interest rate that’s fractionally lower than another but costs you thousands of dollars in discount points to get it.

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