Unless you have been in the home loan market for a while, you may not understand the concept of discount points. The basic explanation of paying discount points is that you are paying some of your interest to the bank upfront in order to lower your mortgage payments later on, during the course of the mortgage. When the rate is less, so will the monthly loan payment.
One point refers to a cost equivalent to 1% of the total amount of the mortgage. For example, for a $200,000 loan, each point would cost $2,000. You can buy more than one point and lower your loan rate proportionately.
As anyone who has been looking for a loan knows, one’s credit score determines the loan rate, and then the point reduction is taken off this rate. If you are quoted 6% on your $200,000 loan, you may receive a different quote for your loan if you were paying points. Each bank has its own formula, but they fall within the same scope, and the norm is that 1 point lowers a fixed rate mortgage by .25% and an adjustable rate mortgage by .375%. 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 floating.
If you inquire about a loan rate, you will most likely see the rate quoted along with points. So, if you see a 6% rate, next to it will be the quotes for 1 point, 2 points, etc. Next you may see 7%, with the appropriate rate reductions per point, and so on for each rate. This is what makes it critical that a borrower know what the point system means.
It is clear that a monthly mortgage payment will be lower with a loan of 5.75% than with a loan of 6%, but you have to take into account the points. This sounds like it would always be a worthwhile investment, but you have to keep in mind that you are really paying interest up front. This is why it is important to look at points with a view to how long you think you’ll be living in the house. 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 bring in more buyers. Even when this is the case, the buyer has to make sure the investment is worthwhile and that he is going to be in the house long enough to make it a difference.
It is important to note that there is positively no obligation on the part of the borrower to pay points. It is merely his decision to lower the interest rate of the mortgage.
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