Recently I wrote an article on how big of a down payment you need to buy a home. Today we’ll look at a question that has perplexed a lot of future homeowners–should you pay discount points to lower your interest rate?

Discount points act as a type of prepaid interest on your mortgage loan. Each discount point is equivalent to one percent of your total mortgage loan. For instance, if you have a $500,000 loan, one discount point would cost $5,000 at closing. For each discount point you pay, the interest rate on your home loan is reduced by about 0.25%. Generally, you can choose not to pay any discount points, or pay up to about three percent of the loan amount, which would reduce your interest rate by about 0.75%.

Should You Buy Down Your Interest Rate

Whether it makes sense to pay discount points depends on one key factor–how long will you have the mortgage. Let’s take a look at an example. We’ll assume your mortgage is for $300,000 and you have the following two mortgage options:

1. 4.5% with 2 discount points costing $6,000 (2% of $300,000), or

2. 5.0% with no discount points.

So which mortgage is the better deal? The 4.5% loan results in a monthly principal and interest payment of $1,520, while the 5% loan results in a mortgage payment of $1,610 a month. Thus, by paying $6,000 in discount points, you’ll save $90 a month. A simple calculation of dividing the $90 of monthly savings into $6,000 tells us that it will take about 67 months to break even.

Of course, it’s not quite that simple. If you itemize your tax deductions on Schedule A, you’ll need to factor in the tax impact of paying discount points. And the lower interest you’ll pay each month if you pay discount points means your interest deduction will be lower. Finally, you’ll need to factor in the lost interest you could earn on the cash you spend to pay for the discount points.

There are some calculators that can help you make these calculations. I like this one here (Hat tip to Jonathan over at My Money Blog for finding this calculator). But another way is to apply the 5-year rule of thumb.

The Five Year Rule

As a general rule, you shouldn’t consider paying points unless you know you will have the mortgage for at least five years. Note that the issue isn’t when you’ll move. You could refinance your mortgage or pay it off in less than five years. So the key is how long you’ll continue paying on the home loan.

If you won’t have the mortgage five years from now, paying discount points is almost always a bad idea. If you think you’ll have the mortgage for more than five years, then discount points may be worth the cost. If you’ll have the mortgage for the long term, say 10 years or more, then the points will almost always be worth the cost. If you think you may be out of the mortgage in five to ten years, ask your mortgage broker to run a break-even calculation for you.

How Many Discount Points Should You Buy

If you conclude that discount points are worth the cost, how many should you buy? At first glance it may seem like an all or nothing deal. After all, if you’ll stay in the mortgage long enough to break even, why not lower your interest rate as much as possible. Theoretically that’s correct.

But there are two practical considerations that deserve attention. First, you may not have the cash to pay for 3 discount points. Second, you may not be positive that you’ll stay in the mortgage long enough to break even. If you’re not sure, you may not want to risk a lot of money in buying down your loan. That’s why a lot of people often pay for just 1 or 2 discount points.

If you are looking to buy or refinance a home, check out today’s mortgage rates.