Unless you have been in the home loan market for a while, you may not be sure about the concept of discount points. The basic explanation of paying discount points is that you are paying part of your interest to the bank in the beginning in order to lower your mortgage payments later on, during the course of the mortgage. Points will lower your overall interest rate, and therefore the monthly payment on your loan.
When lenders talk about a point, they mean 1% of the entire loan. For example, for a $200,000 mortgage, each point would cost $2,000. The more points you are willing and able to pay, the lower the rate on your loan will be.
Your home loan rate is determined primarily by your credit worthiness, but whatever the rate on the loan, paying points will bring it down. For example, if the original rate quote is 6%, based on your credit score, ask how much it will be if you are willing to pay any points. There is no set amount, but most lenders will lower a fixed rate loan by .25% and an adjustable rate loan by .375% for each point paid. In the case of your $200,000 mortgage that you are willing to pay $2,000 for one point, your loan would then be reduced to 5.75% for a fixed rate loan and 5.625% for an adjustable rate loan.
Most banks will give mortgage interest rates with optional points alongside. So, if you are given a 6% rate, next to it will be the quotes for 1 point, 2 points, etc. Then the table would show 7% with the relevant reductions. This is what makes it important that a borrower know what the point system means.
Obviously, your mortgage payment is going to be lower on a loan with 5.75% or 5.625% than it would be on a loan with a 6% rate. What the borrower is really doing is paying a part of the interest ahead of time. This is why it is important to examine points with a view to how long you think you’ll be living in the home. In other words, you need to amortize the payment amount for the points over how long you think you will have the loan.
Many times home sellers use points to get buyers. This is why you may see homes advertised with an offer that the seller is willing to pay points. But keep in mind that this may increase the price of the house by the amount of the points.
Borrowers do not have to pay points, only if they are interested in reducing the rate. It is a completely voluntary decision based on the borrower’s analysis of the costs involved.