What happens when a borrower pays points on a loan?

When a borrower pays points on a loan, it serves the purpose of reducing the interest rate charged on that loan. Points, often referred to as discount points, are a form of prepaid interest that the borrower can choose to pay at the outset in exchange for a lower interest rate for the duration of the loan. Essentially, each point is equal to one percent of the loan amount.

By paying points, borrowers can negotiate a lower rate, which can lead to significant savings over the life of the loan. This is particularly advantageous for borrowers who plan to hold the mortgage for a long period, as the reduced monthly payments can offset the initial cost of the points over time.

The mechanism works because the lender receives upfront cash to compensate for the lower monthly interest payments. Therefore, by opting to pay points, the borrower effectively makes an investment in their mortgage that yields long-term financial benefits.

In contrast, while paying points may influence other aspects such as upfront costs or mortgage approval, the primary and most significant effect directly related to the points is the reduction of the interest rate.