Homeowners should know many key mortgage terms, and two of the most important terms relate to lowering your home loan interest rate: discount points (also known as, mortgage points or prepaid interest points) and lender credits (also known as, loan origination fees). And if you thought they were the same, then make sure you read this article from beginning to end (because they’re not).
Knowing what they are, how to calculate their cost, and the differences between the two terms will prepare the homeowner for a more successful home loan process. Below, I’ll also cover, if they are required, your potential tax implications and a pro tip on ensuring your loan officer is not hiding any fees.
What is a discount point?
A discount point is a fee a homeowner can pay at closing to lower their interest rate. The lender charges the discount point, and the amount the homeowner pays goes directly to the lender to get a lower interest rate. Each discount point costs 1% of your loan size, and it typically lowers your mortgage rate by about 0.25%.
Here is how you calculate the cost of a discount point
If your mortgage lender offers you the option of paying one discount point, that means you are paying a fee equal to 1% of the amount you are borrowing. If your loan amount is $400,000 and you are paying one discount point, you are paying a fee of $4,000. If you were to pay two discount points, you would be paying a fee of $8,000.
Discount points may extend beyond the decimal point. For example, a homeowner might see 1.03 discount points or even 0.88 discount points. No matter the configuration, the discount point charged always results in a fee, and the discount point is always a percentage of the loan amount you borrow.
It’s rarely an equal tradeoff
When you are paying a discount point to lower your rate, your rate does not go down by 1.00%. And if you pay two discount points, it does not mean your rate is going down by two percent. Simply put, there is no set formula for how much lower your mortgage rate will be if you pay “X” in discount points.
If you pay one discount point, you might see a 0.125% to 0.50% reduction in your interest rate. If you decide to pay two discount points, it could result in a 0.375% to 0.75% reduction in rate. The dynamics of paying points and lowering your rate change daily. Factors such as market fluctuations and lender volumes play a role in determining the relationship between paying points and a potential rate reduction.
What are lender credits (loan origination fees)?
A lender credit, or loan origination fee, is an amount charged by a mortgage lender for the processing and closing of your loan application. Like discount points, loan origination fees can appear on both purchase and refinance transactions, and your fee is also expressed as a percentage of the loan amount.
While it’s technically true that a loan origination fee does not lower your interest rate, it might. How is that possible?
Suppose your mortgage lender needs to generate $2,000 in revenue to cover the cost of originating your loan. In that case, they may offer you the option of paying a loan origination fee or raising your interest rate to cover the cost. Like a discount point, you might be offered a lower rate if you pay a loan origination fee.
Are discount points and loan origination fees required?
Discount points and loan origination fees are not required when purchasing a home or refinancing a current mortgage.
There is a caveat to this. When your loan amount is below $250,000, you might have to pay discount points and/or origination fees. Why? It has to do with loan size and lender revenue requirements.
A lender typically targets a general revenue goal that each loan they process and close must meet. Let’s say that the revenue goal is $5,000 per closed transaction. On a $500,000 loan amount, that’s 1.00% of the loan, but on a $250,000 loan amount, that’s 2.00% of the loan. So, for the homeowner with the smaller loan amount, the lender might have to charge a discount point and/or a loan origination fee to meet their required revenue goal.
Should you pay discount points or loan origination fees?
It depends. I suggest you request the loan officer present you several options to consider, including discount points and/or loan origination fees and options without. Then, sit down and do some basic math to see if paying a higher fee for a lower rate makes sense. Only the homeowner can make this decision, but I suggest you discuss your options with your tax advisor and loan officer.
Here are a few key points to remember when making this important decision.
- Have a clear understanding of how long you plan on keeping the loan.
- Before deciding, know exactly how long it will take to recoup the cost of paying more in fees.
If you only think you’ll keep the new loan for a year or two, does paying fees to get a lower rate make sense? Probably not. Or if it’s 2023 and rates are at a thirty-year high, does it make sense to pay fees to get a lower rate? Maybe, but most likely not, since there is a good chance that interest rates will move lower over the next few years.
Now, if it’s 2022 and you can get a 30-year fixed rate at the lowest rate ever on your forever home, does it make sense to pay fees – probably, since the odds are you’ll never see that rate again.
Ideally, you want to recoup the fees you pay within three years. The decision on whether you should or should not pay fees to obtain a lower rate always needs to be made knowing the answers to the two bullet points above and within the context of where the interest rate market is at. Also, if you plan to stay in your home a long time, then you can afford to have a longer payback period on the fees.
It’s important to pay attention to the words the loan officer uses. If they say “zero points,” don’t assume that includes loan origination fees. I have seen many “zero point” quotes from loan officers that list loan origination fees, so never assume anything.
How you ensure you are going to a quote that is an accurate representation of what you are going to pay is simple. Ask the loan officer the following question;
“Does this quote include all possible fees, including all discount points and/or loan origination fees that might be charged to me?”
This question lets the loan officer know you are familiar with the different terms, and they should not try to hide any fees that might be charged.
The five-year rule
As mentioned above, you usually want to recoup your fees for the lower rate within three years. Not always, but usually. However, there is a good rule of thumb for the absolute limit on the time frame to recoup your cost. That is the five-year rule.
If you are doing a loan in which you are paying points to obtain a lower rate, make sure you recoup the cost associated with the lower rate within five years. If it takes more than five years, don’t do the loan. So many things can happen within those five years, such as selling the home or refinancing the loan. Even if you plan on staying in your home “long term,” I strongly suggest you follow the five-year rule.
Are discount points and loan origination fees tax deductible?
Possibly. You’ll need to talk with a tax professional to determine if discount points and loan origination fees are tax deductible for your future IRS filings. Suppose your tax professional says any potential discount points you pay are tax deductible. In that case, you’ll then want to evaluate if the tax deduction is worth the expense of paying higher fees.
Over the years, loan origination fees have generally not been tax deductible; however, each year, Congress passes a new set of tax laws, so it’s good to ask your tax professional about this so you have the most current information.
The last word on discount points and loan origination fees
Knowing what a loan discount point and origination fee are will help you prepare for the home loan process. Being able to accurately talk about the difference between discount points and loan origination fees will let lenders know that you are informed and educated, which might result in better offers from them.
The homeowner should make the decision to pay or not pay these fees with the advice of the loan officer you are working with and your tax professional.