Mortgage points and lender credits

#What a discount point is

A discount point is prepaid interest: you pay 1% of the loan amount at closing for each point, and the lender lowers your rate for the life of a fixed-rate loan. Lenders also quote fractions of a point, such as a quarter or three-eighths.

According to the CFPB, how much the rate drops for each point depends on the lender, the kind of loan and market conditions — there is no standard exchange rate. Points appear on page 2 of the Loan Estimate in section A, “Origination Charges.” Origination fees sit in the same section but don’t lower your rate, so ask the lender which charges are discount points.

#Break-even: when points pay off

The simple test is the cost of the points divided by the monthly saving. The fuller test also counts the fact that a lower rate pays the balance down faster.

Before the break-even month, you would have been better off without points; after it, you are ahead every month you keep the loan. The CFPB suggests comparing total costs over the shortest, longest and most likely time you expect to keep the loan. An option that wins in all three is a safe choice. Our refinance break-even calculator runs the same arithmetic for a new rate against costs.

#Lender credits: points in reverse

Lender credits lower your closing costs in exchange for a higher rate; lenders sometimes call them negative points. They show up as a negative number on the Lender Credits line in section J of the Loan Estimate.

Using the same example assumption in reverse, a credit of $3,240 for a rate 0.25 percentage point higher would add about $55 a month, so the credit stays ahead for roughly 4 years, 10 months. If you expect to move or refinance before then, the credit is the better deal — and it keeps cash in your pocket for the down payment or reserves. See closing costs for what credits can cover.

#When points make sense

Points tend to pay off when:

• You expect to keep the loan for many years, well past the break-even month.
• Rates are unlikely to fall far enough to make you refinance — although no one can know that in advance.
• You have cash to spare after the down payment, closing costs and an emergency fund.

They tend not to when:

• You might move, sell or refinance within a few years.
• The money would do more elsewhere. Putting the same cash toward a larger down payment can cut PMI or lift you into better pricing — compare the options in our down payment guide.
• The loan is adjustable. On an ARM the discount usually only matters during the fixed period.

Deciding between points and a larger down payment? See points or a bigger down payment.

#Points and the Qualified Mortgage cap

A Qualified Mortgage gives the lender legal protection, and in return the points and fees it charges are capped. On loans of the size in our example, total points and fees generally can’t exceed 3% of the loan amount — $9,720 on a $324,000 loan. Some bona fide discount points can be left out of the count when the rate before the discount is close to the market average, but the cap is one reason a lender may limit how many points you can buy. Smaller loans have higher percentage caps.

#Are points tax-deductible?

IRS Publication 936 treats points as prepaid interest. The general rule is that you deduct them gradually over the life of the loan. You can deduct them all in the year you pay them if the loan is to buy or build your main home and several tests are met, including:

• paying points is an established practice in your area, and the amount is typical there;
• the points are figured as a percentage of the loan and clearly shown as points on your settlement statement;
• the cash you brought to closing, plus any points the seller paid, at least equals the points.

Points on a refinance are generally deducted over the life of the new loan, and points the seller pays are treated as paid by you. You only benefit if you itemize, and the mortgage interest deduction is limited to interest on up to $750,000 of mortgage debt for loans taken out after December 15, 2017. Check the publication or a tax professional for your situation.

Points are one way to shape the rate; the mortgage rates guide covers the rest, and the buying a home hub shows where the decision fits. FHA borrowers can buy points too — see the FHA loans guide.