Discount points are not an easy topic for many new homebuyers. 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 loan. When the rate is lowered, so will the monthly loan payment.
When lenders speak of a point, they mean 1% of the total loan. If you are obtaining a $200,000 mortgage, one point would cost you $2,000 at closing. A borrower has the option of paying one or more points on the loan.
The original interest rate on the loan will still be predicated on the credit standing of the borrower, but paying points will bring that original rate down. For example, if the original rate quote is 6%, based on your credit score, ask how much it would be if you are willing to pay any points. Each bank has its own formula, but they fall within the same limits, 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 paragraph, 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. For example, the bank may list the rate as 6%, no points, 5.75%, one point, 5.5%, two points, etc. Next you may see 7%, with the appropriate rate reductions per point, and so on for each rate. This is why it is necessary to know your original rate and then calculate downward for points.
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. Lowering the rate in this way is because you are really paying some of your interest ahead of time. This is why it is important to look at points with a view to how long you plan on living in the home. In other words, you have to amortize the payment amount for the points over how long you plan to have the loan.
Points are often used as a sales gimic, since homeowners will have a lower payment and can pay more for a home. For this reason, sellers frequently offer to pay points as a sales inducement. But this shouldn’t change the original calculations, because the price of the home will reflect the seller’s contribution.
Borrowers do not have to pay points, only if they are interested in reducing the rate. It is merely his decision to reduce the interest rate of the loan.
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