What are Discount Points?
Discount points on mortgages serve two purposes. One is to increase income for the lender or two is to lower interest rates for the borrower. You can imagine what the lender wants to do.
Discount points are a function of mortgage interest rates. Since most mortgage are sold in what is known as the secondary market, there is a market interest rate for mortgages that is determined at least once daily. So all mortgage interest rates are the same at any given time.
Discount points are way to adjust interest rates. If current interest rates for a thirty year mortgage are 4.5% than that is called a par rate. Any adjustment to that rate will mean a change in the discount points. For example, with a thirty year mortgage, each adjustment of 1/8% in interest rate means discount points of .50% will be paid or received.
Interest rate premium
Since the discount points are a function of the interest rate, the interest rate that a borrower will pay on mortgage can be adjusted by manipulating discount points. If a mortgage broker wants to make an extra .50% on a loan closing, the broker can quote a rate that is higher than the 5.50% par rate by 1/8%. When a higher than par interest rate is paid, the broker receives an interest rate premium which is also known as a discount points.
When the borrower pays discount points to "buydown" the interest rate to a lower rate it is known as a buydown. For example, a borrower could pay .50% in discount points and lower the interest rate from 5.50% to 5.375%. If the borrower paid 1% the rate would then be 5.25 %.
Knowing how mortgage discount points work can save a borrower a significant amount of money in up front costs and in monthly mortgage payments. An understanding of mortgage discount points should allow borrowers to negotiate more favorable loan terms.
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