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Discount Points
Explanation:
Discount points are a form of prepaid interest that can be paid at the time of origination in order to lower the interest rate charged for the duration of a mortgage. One point costs 1% of the loan amount. For example, 1 discount point on a $100,000 mortgage would cost $1,000. Discount points are tax deductible in the year in which they are bought.
In general, buying one discount point will lower the interest rate on a 30-year mortgage by 0.125%, and the longer you plan on having your mortgage, the more sense it makes to buy a discount point.
In order to figure out whether purchasing discount points makes sense in your particular situation, you must determine 1) by exactly how much the discount point(s) will lower your interest rate; and 2) how the cost of purchasing the discount point(s) compares to the interest you will save with the lower rate over the amount of time you expect to have the loan in question.
Sometimes lenders also charge "origination points" to cover part of the cost of making a loan.
Our Thoughts:
For example, if you take out a $300,000 mortgage with an interest rate of 4.125% and it will take you 30 years to pay it off, the total cost of the loan will end up being $523,440. If you were to buy a discount point for $3,000 and thereby bring your interest rate to 4.0%, then the total cost of the loan would be $515,880, assuming you'd pay it off in the same 30-year time frame. The amount you save in interest ($7,560) would be greater than the cost of the discount point ($3,000), which means that purchasing the discount point would be a good idea. However, it's important to keep in mind that almost no one holds a loan over the course of 30 years, so you must figure out how long you expect to keep your original mortgage for and adjust accordingly.