The process of reducing a mortgage interest rate is usually referred to as paying discount points. A discount point is typically 1 percent of the loan amount and it reduces the interest rate by about a quarter percent. The more discount points a borrower pays, the lower the interest rate on their loan will be. For instance if a borrower of a loan of $100,000 who qualifies for an interest rate of 5 percent was to buy down their rate by a one discount point, it will cost $1,000 and reduce their interest rate to 4.75 percent.
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Discount points are ideal for borrowers who want to save money in overall loan payments over the course of the loan. However, it is feasible only if the borrower has upfront cash to buy down the interest rate. Also while buying down points might seem like a good idea for any borrower, the fact remains that the borrower will benefit only if they plan to stay in the house and hold the loan for quite some years. This is the only way to realize the full benefits of discounts points.
Discount points also lowers the monthly mortgage payments since the payments are calculated based on the amount of the interest rate. The higher the interest rate, the higher the monthly loan repayments. Paying upfront interest rate can therefore become attractive to the borrower who does not have a lot of cash to spend on the monthly basis but has upfront cash to bring to the settlement table.
Another advantage of discount points to the borrower is that they get to deduct the points on their tax returns in the year the point was paid for. The advantage for lenders is they get a chunk of the interest charges upfront in cash as opposed to them realizing it over the term of the loan. In this case, it is a win-win scenario for both lender and borrower.