Unless you have been in the mortgage market for a while, you may not understand the concept of discount points. It is a simple enough idea: in order to lower the interest on your mortgage, you pay your bank some cash upfront as an incentive to lower the rate. When the rate is less, so will the monthly mortgage payment.
One point equals 1% of the loan, and it is remitted to the lender at the closing of the mortgage. If you are obtaining a $200,000 loan, one point would cost you $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 determined primarily by your credit worthiness, but whatever the rate on the loan, paying points will bring it down. If you are quoted 6% on your $200,000 mortgage, you may receive another quote for your loan if you are paying points. Each bank has its own way of figuring this, 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%. If we use the $200,000 mortgage in the above example, and we pay one point, we can lower the rate to 5.75% on a fixed rate and 5.625% on an adjustable rate loan.
Most banks will give mortgage interest rates with optional points along with them. So, if you are given a 6% rate, next to it will be the quotes for 1 point, 2 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 important that a borrower know what the point system represents.
Obviously, your loan 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. This sounds like it would always be a good investment, but you must keep in mind that you are basically paying interest up front. This is why it is important to examine points with a view to how long you plan on living in the house. In other words, you need to amortize the payment amount for the points over how long you plan to have the loan.
Many times home sellers use points to encourage buyers. For this reason, sellers frequently offer to pay points as a sales pitch. But keep in mind that this may increase the price of the house by the amount of the points.
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 reduce the interest rate of the loan.
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