Electing to use lender credits or discount points when buying a home is like getting on a see-saw: You need to have an exit strategy. With lender credits, you want to get on the see-saw for a short enough time to jump off before your costs outweigh your savings. With discount points, you want to stay on for a long enough time for your savings to outweigh your costs.
But knowing when you reach the point in your mortgage for lender credits or discount points to make sense can be confusing. Still, these financing options can be powerful tools for homebuyers to lower their costs by either paying more upfront (in discount points) or paying less up front but more in interest over the lifetime of the loan (in lender credits). Just make sure you know when you’ll end up on top.
Discount points are fees homebuyers can opt to pay in order to lower their interest rate. They are a powerful tool to help homebuyers lower the cost of homebuying by paying part of their mortgage costs upfront. If you opt to pay points, your lender lowers the interest rate by a certain amount for each point.
You'll sometimes hear discount points referred to as mortgage points, and they are the foundation of the rate buydown strategy.
Tip: Lenders will sometimes roll discount points into the rates they advertise online. Read the fine print to be sure that the rate you’re seeing doesn’t already include discount points.
A single discount point is worth 1% of the total amount you're borrowing. For example, if you're taking out a mortgage for $200,000, each discount point will cost $2,000. It's also possible to buy a fraction of a point. You can pay for 1.75 points that are each worth $2,000, or (1.75 X $2,000) $3,500 in total.
How much a point will lower your interest rate depends on your lender, but it's typical for one point to reduce the interest rate by 0.25 percentage points.
To understand how your rate will be affected by paying points, start with the lender's baseline interest rate that doesn't take into account any points or credits. This rate is known as the par rate. Then subtract the number of points times the discount each point gives you.
New interest rate = par rate - (number of points X lender rate)
So if the par rate is 5% and you are buying two points that each lower the rate by 0.25 percentage points, your adjusted interest rate will be 5% - (2 X 0.25%) = 4.5%.
Lender credits, or negative points, are the opposite of discount points. Borrowers agree to pay a higher interest rate for the lender to absorb some of their closing costs. If you decide to accept lender credits, your lender cuts your closing costs by a certain amount for each credit. But at the same time, each credit drives your interest rate higher. Lender credits let you pay less at closing, but give you a higher interest rate and higher monthly payments.
Like discount points, each lender credit is worth 1% of your loan amount. That means on a $200,000 mortgage, one lender credit will reduce your closing costs by $2,000. Just like mortgage discount points, you can get a fraction of a lender credit. For example, if one lender credit is worth $2,000 and you take 0.5 credits, then the lender is giving you half of that (or $2,000 X 0.5) which is $1,000 toward closing costs.
For each lender credit you receive, your interest rate goes up. How much the interest rate rises depends on your lender, but as an example, let's say your lender offers one credit for an interest rate increase of 0.25 percentage points. If the baseline interest rate is 5% and you are taking two lender credits, your new, adjusted interest rate will be 5% + (2 x 0.25) = 5.5%.
Interest rate = base rate + (number of lender credits x percentage points)
The second page of your Loan Estimate will detail if the loan includes the option for discount points, lender credits, or neither. Discount points will be listed in Section A along with the positive amount you'll pay for them when you close on the loan. Lender credits will appear in Section J with a negative amount that shows how much your closing costs are being reduced.
And of course, you can always ask your lender.
If you buy discount points, you're paying more at closing but enjoying a lower monthly payment later. And if you get lender credits, you're paying less at closing but making higher monthly payments in the future. In both cases, you're making a trade between what you owe now vs. what you'll have to pay going forward.
To see whether the tradeoff is worth it, you need to find the break-even point — when the amount you've saved on your monthly payments equals the extra money you spent at closing (for discount points), or when the extra amount you've paid monthly equals the money you saved at closing (for lender credits).
You can find the break-even point by dividing the money you spend upfront by the monthly savings. This will give you how many months it will take to break even.
Break even point = cost of discount point or lender credit / monthly savings
Suppose you spend $1,000 on a discount point, and the lower interest rate you get as a result gives you a monthly payment that's $20 lower. Divide $1,000 by $20 per month and get 50 months. It will take 50 months, or a little more than four years, to break even on this discount point.
In other words, if you're going to stay in your new home for longer than 50 months, your savings will outweigh the cost of the discount point. But if you're planning to move after three years, for instance, you will have spent more on the point than you saved during those three years, and the discount point won't benefit you.
The math for lender credits is similar. Divide the money you save upfront by the monthly increase in your mortgage to find the amount of time it will take to break even.
Let’s say you get a $1,000 lender credit in exchange for a monthly payment that's $20 higher. Divide your $1,000 lender credit by $20 per month to get 50 months. It will take 50 months for the extra payments to add up to more than you saved at closing. So accepting this lender credit makes sense only if you're going to sell the home or refinance within 50 months.
Buying discount points may be a good option for you, if:
If your mortgage is a conventional loan and you’re making a down payment of at least 20%, discount points are more likely to be a good deal for you.
That's because when your down payment hits 20%, you get to avoid paying private mortgage insurance (PMI). So if you're currently planning for a down payment that's under 20% and you have extra money to spend at closing, increasing your down payment to avoid having to purchase PMI may be a more cost-conscious option than buying discount points.
On the other hand, if you're prepared to put at least 20% down and you have extra cash left over, it may be smarter to spend money on discount points instead of making your down payment even bigger.
Another thing to consider is that making a larger down payment can generally help you score a better interest rate and a lower monthly payment on your mortgage. In some cases, you could save more on interest by increasing your down payment, while in other cases, you'll come out ahead by using that money to pay for points.
You may want to ask your lender to show you the interest rate and total interest you'll pay for a loan with a larger down payment and for a loan with discount points so you can compare the two options side-by-side.
You might benefit from accepting lender credits if you're planning to move again within a few years, or before the break-even point, when the amount you save on closing costs from lender credits will be larger than the additional interest you have to pay.
Similarly, if you expect to refinance before the break-even point, taking lender credits might also be a good option. You can use the money you aren't spending on closing costs now to get a head start saving up for the closing costs on that refinance. However, counting on interest rates to drop could be a gamble.
Discount points and lender credits are two sides of the same coin: Lenders use both to offer you a tradeoff between paying more when you take out your mortgage vs. paying more later. As a result, you may have more options to choose from as you shop for a home loan.
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