Unless you have been in the home loan market for some time, you may not be sure about the concept of discount points. It is a simple enough concept: in order to reduce the interest on your loan, you pay your bank some cash upfront as an incentive to lower the rate. Points will lower your total interest rate, and therefore the monthly payment on your loan.
One point is a cost equivalent to 1% of the total amount of the mortgage. If you are obtaining a $200,000 loan, one point would be $2,000 at closing. The more points you are willing and able to pay, the lower the rate on your loan will be.
Your home loan rate is calculated primarily by your credit worthiness, but whatever the rate on the loan, paying points will make it lower. If you are quoted 6% on your $200,000 loan, you may receive a different quote for your loan if you were paying points. A general rule, but one that changes from bank to bank, is that one point will lower the loan rate .25% on a fixed rate loan and .375% on an adjustable rate loan. In discussing our example of a $200,000 mortgage, above, let’s say we want one point, that is, to get the loan rate reduced to 5.75% of 5.635%, depending on whether it is fixed or adjustable.
If you inquire about a loan rate, you will most likely see the rate quoted along with points. For example, the bank may list the rate as 6%, no points, 5.75%, one point, 5.5%, two points, etc. On the next line, will be the quotes for 7%: 6.75% (1 point), 6.5% (2 points), etc. This is what makes it critical that a borrower know what the point system means.
Obviously, your mortgage payment is going to be lower on a mortgage with 5.75% or 5.625% than it will be on a loan with a 6% rate. This sounds like it would always be a worthwhile investment, but you have to keep in mind that you are basically paying interest up front. This means that if you do not have that loan for a long time, you will have prepaid this interest for no reason. You have to spread the cost of these points over the time you plan on living in the home.
Points are often used as a sales technique, since homeowners will have a lower payment and will pay more for the house. A seller may advertise “seller pays points” to attract more buyers. But this doesn’t change the original calculations, because the price of the house will reflect the seller’s contribution.
It is important to note that there is absolutely no obligation on the part of the borrower to pay points. It is merely a decision to lower the interest rate of the mortgage.
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