Example: Three (3) discount points charged by a lender on a $100,000 loan would be $3,000.  At closing, the borrower only receives $97,000 since points are deducted from the loan amount received.

Points can be charged by the lender for originating the loan or to "equalize" the contract rate of interest actually charged with current market rates.  They are equivalent to prepaid interest.   Charging points allows a lender to remain liquid by selling the long term mortgage note at a competitive  "market" interest rate when the "contract"  rate is discounted to the borrower.  

Why do lenders charge discount points?

Discount points are usually charged when the lender makes a mortgage loan with a  contract rate of interest  lower than the current market interest rate.  This generally occurs for two reasons:

• The rate of interest charged is lower than what investors may be willing to pay for the mortgage in the secondary market. 
• The borrower may "buy down" the interest rate with discount points.  

Essentially, it increases the "yield" for the lender making the mortgage more attractive to secondary market investors. "Yield rate" measures the entire return over the life of the loan and "yield" is usually higher than "interest rate" which merely reflects a "return on" the principal amount loaned.   Discount points are only charged when necessary but usually in rising interest rate markets where the future is uncertain or when the borrower selects a "buy down" option.  

Discount points differ from "origination" points  which reflect a fee routinely charged by the lender for processing  the paperwork.  Discount points are always charged on VA loans due to their "below market" interest rate but  this fee may not be paid by the borrower.  Points charged for FHA and Conventional loans are paid by the borrower although purchase contracts may specify that the seller pays these points and/or other closing costs to help qualify the buyer for the loan, otherwise, the seller may be unable to sell.  

What is yield?

Yield is simply the overall return, expressed as a percentage, that an investor receives on an investment - in the case of the lender, it is the mortgage loan.   Although lenders price mortgages based on anticipated yield, the actual "yield" received by the lender is really not determined until after the loan is sold and  the lender receives a profit or when the loan is paid off.  Time and changing markets influence lender yield at any given time.  

What is the benefit to borrowers?

A lender could be limited by law to a maximum "contract" interest rate for a particular type of  mortgage such as a VA loan.  Also, a lender may want to keep rates  low for marketing considerations.  

Unless points were charged to increase the "yield",  the lender would not be willing to make the loan.  Further, the loan could not be sold in the secondary market to an investor due to the "below market" contract  interest rate.   Points "equalize" the yield to market level for the benefit of the lender and subsequent investors who may purchase the loan.  The borrower benefits by the greater availability of mortgage funds.    

Rule of Thumb  -  How do points impact rate/yield?

Generally, one (1) discount point will adjust the effective interest rate of the loan about one-eighth (1/8) of 1 percent.

Example:  A loan has a 12% interest rate but the lender needs to "match" (adjust) the yield with the current market rate of 12 1/2 % in order to make the loan.  Therefore, a  4 point fee must be charged at closing.   (4 x 1/8 = 1/2 %).  

On a $100,000 loan,  4 points provide an extra $4,000 fee to the lender.   Since the lender has collected the additional fee to offset the lower contract rate,  the $100,000 loan can then be sold with a 12% interest rate in the secondary market for $96,000 allowing the "investor" to yield  12 1/2 %.   

Most conventional, FHA, and VA  lenders "sell off" their mortgage loans at a "discount" to investors with the discount reflecting the difference between the actual  face amount of the note and what an investor really pays the lender for the note. 

Unless the "yield" can be adjusted to reflect current interest rate conditions, the lender won't make the loan and the loan cannot be sold. For loans retained "in house", discount points increase lender return (yield) through the receipt of "present dollars" (points) collected at closing as opposed to "future dollars" (interest) collected over time. Origination fees have little to do with the interest rate charged but rather reflect a service fee lenders charge for making the loan. It is however considered in the total loan costs which must be budgeted for at closing.