Mortgage discount points are an optional fee that some borrowers choose to pay to their lender in exchange for a lower interest rate on their mortgage loan. This upfront fee is based on a percentage of the loan amount, and one point equals 1% of the loan amount. For a $400,000 mortgage, one point would cost $4,000. Some lenders allow fractional points, such as one-eighth, one-quarter, or one-half of one point.

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However, the rate reduction is not one-to-one. One discount point typically lowers your interest rate by 0.25%. That means paying $4,000 for one discount point on a 7% mortgage would lower the rate to 6.75%. Not every discount point program is the same. A lender’s cost-to-reduction ratio can vary based on the market and their own pricing strategy. So, it’s essential to compare several lenders before committing.

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How to Decide Whether to Pay Discount Points

It’s not always easy to determine whether paying discount points makes sense. Here are four tips to help you decide:

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Tip 1: Prepare a Breakeven Analysis

A breakeven analysis compares the cost of your discount points to your monthly savings from your lower rate. This analysis can help you figure out when your total savings will equal your upfront cost. To calculate your breakeven, divide the total cost of your discount points by your monthly savings. The resulting number is how many months it’ll take you to recoup the costs.

As a general rule, paying points may be more attractive if you’re planning to keep your home and your mortgage for at least a few years after you recoup your upfront cost. For example, one discount point on a fixed 30-year $400,000 mortgage at a 7% interest rate lowers your rate to 6.75% and costs $4,000. This saves about $67 per month, which means you’re breaking even in roughly 60 months or about five years.

Tip 2: Consider Your Cash Position

You can pay for discount points upfront in cash, along with your closing costs. But if your cash is limited or you’re planning to make a lot of repairs or improvements to your home right away, you may not want to pay discount points upfront. Two other options are to finance discount points as part of your loan amount, which may increase your payment or interest expense, or negotiate for the seller of the home you want to buy to pay discount points for you.

Tip 3: Consider Your Income Tax Situation

Mortgage discount points may be tax-deductible. The IRS treats points like prepaid mortgage interest, so claiming them can lower your taxable income for the tax year in which you paid them. However, you must meet IRS requirements. To start, you’ll have to itemize your tax return to claim the deduction. The points must be for a loan used to buy or significantly improve your primary residence. Discount points on refinanced mortgages are handled differently.

There are several additional IRS rules, and they can be complex. It’s worth discussing your specific situation with a tax professional.

Seller-Paid Discount Points

Sometimes sellers are willing to buy mortgage points on the buyer’s behalf. It’s one of many seller concessions buyers can ask for, especially in cooling housing markets where there are more homes than there is demand.

With the seller buying down the interest rate, you get the full benefit of a rate reduction without much of the downside. And in a high-interest-rate environment, the monthly savings from a seller rate buydown could be more substantial than asking for a lower purchase price.

Discount Points or Temporary Buydown?

Discount points are a permanent rate buydown. However, there’s also a temporary buydown option. With a temporary buydown, you or the seller pays the upfront cost for a short-term rate reduction, usually lasting one to three years. It’s often a strategy buyers choose if they plan to sell or refinance before the temporary buydown period ends.

Temporary buydowns typically have the lowest rate in the first year, with increases each year thereafter, depending on the structure. For example, a 2-1 buydown reduces the interest rate by 2% in year one. It then increases by 1% in year two and returns to the original rate in year three.

Ultimately, the decision to pay discount points or opt for a temporary buydown depends on your individual circumstances and financial goals. It’s essential to weigh the pros and cons and consider your plans for the future before making a decision.