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Loan Amount Disbursed = Face value of Mortgage in the contract *(1-discount points).

Why do we have this type of computation in place in the US? Is this conventional because of some history behind it?

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    Are you asking what discount points mean (e.g. what the net effect is) or the history behind the practice?
    – D Stanley
    Sep 30, 2019 at 13:05
  • Both would be great. But the history is what I am primarily interested in or the motivation of it. I always thought of it as some sort of marketing tool such as $1.99 pre-tax for commercial transactions. Any thoughts?
    – Frank Swanton
    Sep 30, 2019 at 14:15

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I can't speak to the history of it - most likely some bank came up with the idea as a way to reduce a borrower's interest rate.

It is effectively "prepaid interest". You pay a "fee" upfront in exchange for a lower fixed interest rate. Whether this is beneficial to you as a borrower depends on how long you keep the mortgage (the longer you keep it, the more beneficial the lower interest rate is).

A "point" is 1% of your loan balance (the amount of interest you save is variable). So if you buy "2 points" to lower your interest rate, effectively you get 98% of your principal balance distributed. Alternatively, you could pay the points at closing instead of rolling them into the loan, but the net effect is the same.

For example, say you apply for a mortgage and the interest rate you are quoted is 3.5%. The bank may also offer a 0.25% "discount" for 1 point. So if you pay 1% of the balance upfront, then the interest rate on your mortgage will be 3.25% instead. Using one of many discount points calculators available, you would need to keep this mortgage for 6 years in order to make up for the upfront cost in interest savings.

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  • How does getting less money reduce your interest rate? ISTM that would raise your effective rate, since while 2% of 100 is (naturally) 2, 2 is 2.06% of 97.
    – RonJohn
    Sep 30, 2019 at 15:03
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    @RonJohn The actual interest rate of your mortgage is decreased, usually more than offsetting the increase in loan balance. I added an example.
    – D Stanley
    Sep 30, 2019 at 15:06
  • Thanks. It would be useful, I think to see how much interest you'd pay if you just increased your original DP by 1%.
    – RonJohn
    Sep 30, 2019 at 15:28
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    @RonJohn: A point affects present value directly. To find the change in interest rate that gives the same effect, you'd need to know all the other variables in the present value of periodic payments equation (baseline interest rate, number of compounding intervals, etc)
    – Ben Voigt
    Sep 30, 2019 at 16:26
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    It is distinct from down payment. Down payment reduces the principal and does not affect interest rate. You prove it by looking at each amortization schedule and graphing out the total interest paid to date for each period. At some point the interest savings will make up for the initial cost of lowering the interest rate. You know it shifts the earlier years down because the interest period is the interest rate times the principal balance. A lower interest rate means lower interest paid.
    – D Stanley
    Oct 1, 2019 at 1:12

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