Discount Points: What's a point?

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Lenders make their profit from the interest paid (yield) on the loans they underwrite. This yield is typically determined by the interest rate the Lender charges on a loan. There are two other means by which the Lender can charge fees: origination fees (recoup expenses) and discount points (increase yield).

Each point (also known as a "percentage point") represents one percent of the loan amount. This is the industry standard measurement used for origination fees and discount points.

Loan Origination Fees

Origination fees are used to cover the administrative costs and service expenses the Lender incurs in processing a loan. More often than not, these fees are charged in each funded real estate transaction and paid at closing by the buyer (unless specified otherwise). For example, if a Lender charges a 1.5% origination fee on a $500,000 loan, the origination fee paid on this loan will be $7,500 (500,000 multiplied by 1.5%) at closing.

Discount Points

Over the life of the loan, the Lender collects the interest paid (yield) on the loan. However, to increase the yield of the loan, the Lender may charge the Borrower discount points at the beginning of the loan's life cycle (at the time the loan is funded). This charge can best be described as an "up-front" payment of interest.

The Lender can also discount points by lowering the interest rate. Because the Lender receives an up-front payment, it is not necessary for the Lender to wait for the loan to mature to collect an equivalent yield amount through the Borrower's monthly loan payments. Thus, the Lender is more inclined to "discount" the loan by offering a lower interest rate for the same loan to the Borrower.

If a Borrower does not have a strong credit or earning history and experiences difficulties in qualifying for financing, paying discount points may increase the Lender's willingness to fund the loan. The Lender's risk of repayment is compensated by the up-front payment, and the Borrower's mortgage payments will be lower. This type of discount is often referred to as a loan "buydown."

High mortgage interest rates may also warrant discounting of points. The discount may be purchased by another party involved in the transaction. Quick and dirty rule: typically, it takes six discount points (6%) on a 30-year loan to increase the Lender's yield by 1%.

If a Borrower wants to reduce the interest rate on a $500,000, 30-year loan from 6% down to 4%, how many discount points will the Lender charge on this transaction? What is the actual charge?

1. Subtract 4 from 6 to arrive at 2 (the difference in interest rates).
2. Multiply 2 by 6 (see "Quick and Dirty Rule") to get 12 (discount points).
3. Multiplying 500,000 (loan principal) by 12% (point = 1% of loan amount) equals 60,000.

The Lender would charge the Borrower $60,000 for 12 discount points. The above calculation will help you compare the various loan packages that Lenders are currently offering. Call your local Lender or Mortgage Broker to discuss your options.

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