When you shop for a mortgage loan in the United States, you are likely to encounter lenders that you will give you quotes that includes both loan rates and points when you ask for the cost of a loan.
Example: This 30-year $200,000 mortgage loan has an interest rate of 4% with a charge of 1 point.
So, what are these mysterious points and why are they important?
In this context, a point is a special type of fee paid from the borrower to the lender. 1 point = 1% of the loan amount. Example: If the loan amount is $200,000 then 1 point equals $2,000.
There are two types of point: origination points and discount points. Origination points are only used to pay the mandatory origination fee. Paying discount points is not mandatory, but you can elect to do it since it will reduce the stated interest rate for the loan.
Origination fee
Instead of simply saying that the origination fee will be 2% of the loan amount, some lenders will instead say the cost is 2 origination points. 3% origination fee = 3 origination points, and so on.
The origination fee is a fee charged by the lender when you obtain a loan. While an application fee can be charged for just sending in an application, an origination fee is only charged for a loan that has been approved and will be paid out.
In the United States, the origination fee is tax deductible if it was used to obtain the mortgage loan and not to pay for other closing costs (e.g. notary fee, inspection fee and preparation costs).
Discount points
Discount points are in essence prepaid interest on your mortgage loan. The more discount points you pay at closing (when you obtain the loan), the lower the stated interest rate on the loan will be.
Borrowers can typically pay anywhere from 0 to 4 discount points.
In the United States, discount points are tax-deductible, since they are essentially interest paid on a loan.
So, it is a good idea to prepay interest? This depends on several factors. Generally speaking, borrowers that intend to stay in their house for a long time and keep paying off the mortgage over time will be more interested in paying discount points upfront, since they want to get the interest down as much as possible. People who only plan to stay in the house for a while before selling it and paying off the mortgage loan are usually less interested in paying discount points. Paying discount points means paying more upfront when you obtain your loan, so it is always a question about paying now (discount points) or paying later (higher interest rate).
If you are struggling to find enough money for a down-payment, closing costs and other costs associated with becoming a homeowner, you might prefer to not splash out money on discount points right now, even if it means a somewhat higher interest rate in the long run.
Example
The bank offers you a $165,000 mortgage loan. The term is 30 year and the interest rate is fixed as 6 percent if you pay no discount points. Your monthly payment (interest + amortization) would be $989.
The bank also offers you another solution. If you pay 2 discount points at closing, they will reduce the fixed interest rate to 5.5 percent.
With a $165,000 principal, 1 discount point equals $1,650. Paying 2 discount points therefore means paying $3,300. If you go for this option, your monthly payment (interest + amortization) would be $937. As you can see, you would be paying $3,300 upfront in order to get the monthly payment down with $52 per month.