What are Discount Points?

When you close on a mortgage, you're typically required to pay a percentage of the loan to the lender. A standard 30-year fixed rate mortgage may come with a one point origination fee. This means you have to pay one percent of the principle to the lender when you get the money. If you're purchasing a $500,000 house, therefore, you'll have to pay $5000 to the lender right as you close.

A discount point is a point above and beyond the points and origination fees required by the lender. If you provide two percent points of the total cost of the loan to the lender up front -- $10,000 -- you can lower your monthly interest rate. Typically, this rate gets lowered by one eighth of a percent for every point you pay. The more points you pay up front, the cheaper it is for you to own your home faster. Moreover, points are tax deductible expenses -- even if your home seller pays out of pocket for them as part of your deal

That said, getting discount points doesn't always make financial sense. You have to calculate your monthly payments with and without the points tacked on. For instance, if you're going to go with a standard one point loan on a $500,000 house, you'll have to pay off the balance of $495,000 over the remainder of your loan. If you opt for two discount points, let's say, you'll only have to pay $485,000 over the long term.

You can calculate your expected monthly savings using simple amortization calculator. Once you've got that number -- say it's $100 a month -- you then divide the amount of the discount points (points you pay above the origination fee) -- which is in our example $10,000 -- by your monthly savings. So, $10,000 divided by $100 a month, gives you 100 months. Thus, it will take you 100 months to break even.

To decide whether or not to pay for discount points out of pocket, take a look at your cash reserves in your bank, your accepted mortgage term, the national interest rates, your credit history, and your anticipated income stream.

All of these variables can come into play to help you determine whether or not to invest in discount points.