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What Are Discount Points and Lender Credits?
When you’re buying a house, there seems to be an endless number of decisions you need to make. One thing you may be hearing about for the first time are mortgage points. Touted as a way to lower your mortgage rate, should you buy them, what are mortgage points and can they save you money? It all depends. For some people, mortgage points can be a worthwhile investment, while for others, they are better left out of the contract.
What are mortgage points?
Mortgage points are a way for you to pay an upfront fee when closing on a house to lower your mortgage rate for the life of the loan. Generally, a mortgage point costs 1.00% of the total mortgage and lowers your fixed-interest rate for the life of the loan by 0.25%. While lenders are not required to offer the opportunity to purchase mortgage points, most allow you to purchase up to three or four points. Mortgage points may also be called discount points. Here’s what this would look like on a $200,000 fixed-rate loan with a 5.00% interest rate if you purchase one or two points, assuming a reduction of 0.25% per point.
|Points||Cost up front||Monthly mortgage savings|
How do mortgage points cut your interest rate?
By their very nature, mortgage points are an arrangement to lower your interest rate for the life of the loan. For a percentage cost of your total loan, you can bring down your rate by 0.25% per purchased mortgage point. Once you purchase your points from the lender, the savings are automatically applied. You are required to pay the full cost of the mortgage points upfront, though.
The interest rate savings are realized slowly over the life of your loan with each payment. For example, the monthly payment on the previous example loan without the points at 4.00% would be $955 per month. When you purchase the two points and bring the rate down to 3.50%, your monthly payment goes down to $898.
What are lender credits?
Lender credits are credits specifically related to the closing costs on your property. Given that legal fees, commissions and other costs can add up to about 6% of your home’s value, these fees can be an obstacle to making an offer.
When your lender offers you a credit, they are absorbing part or all of your closing fees. In exchange, you will pay a higher interest rate throughout the life of the loan so that the lender can recoup the costs. How much is your rate increased when you do this? Well, that depends, but in general, you receive a specific amount of credit for each 0.125% interest rate increase on your mortgage loan.
For example, here’s how a lender credit would affect your 30-year costs on a $250,000 mortgage:
|No lender credit||Lender credit with 1.3% increase|
|Original mortgage amount||$250,000||$250,000|
|Total 30-year cost||$429,673||$436,446|
In the above example, using a lender credit would add more than $16,000 to the total cost of the loan. Depending on the amount of the credit, it may be more cost effective to come up with the cash for fees up front rather than relying on a credit.
|Mortgage/discount points||Lender credits|
|Are paid upfront in one lump sum||Are paid over the life of the loan via higher interest rate|
|Lower the interest rate on the mortgage||Increase the interest rate on the mortgage|
|Increase the upfront costs||Lower upfront costs|
Who would benefit from lender credits?
Lender credits aren’t the right fit for every buyer, but they can help a few key groups close on a home more easily than they otherwise could.
While a lender credit will ultimately increase your monthly payment, it also helps you avoid taking out a second mortgage or using other costly methods to cover the property’s closing costs.
In general, lender credits are best for buyers who:
- Are low on cash up front and can’t cover closing fees
- Want to buy a home at the very top of their budget
- Are trying to keep their initial payment low to keep money on hand for improvements
- Can’t get approved for down payment assistance or don’t have time to apply
Pros and cons of mortgage points
The debate on the merits of mortgage points is best settled by looking at the pros and cons. The reality is that for some people buying mortgage points will bring big savings, and for others, it would be a wasted investment.
- Lowers your interest rate: The biggest pro of mortgage points is that it lowers your interest rate for the entire duration of the loan.
- Lowers your payments: When your interest rate goes down, the size of your payments also goes down.
- Can generate long-term savings: If you stay in your home past the break-even point and don’t refinance, you can generate a lot of interest savings on your loan.
- Requires upfront costs: Mortgage points must be paid in full upfront. This can be pricey, especially when you’re already paying all of the other costs of buying a home.
- Negated with refinancing: If you refinance before the break-even point, you will lose out on a lot of the money that you paid for the points. There are no refunds for the costs.
- Not good if you aren’t staying: If you leave before the break-even point, you’ll cease to get any more of the savings that you paid for.
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