What is the purpose of “discount points” in a mortgage?

Discount points serve a specific function in the context of mortgages that involves the financial dynamics of lending. Essentially, these points are upfront fees paid by the borrower to the lender at closing. Each point typically costs 1% of the total loan amount and allows the borrower to "buy down" the interest rate on the mortgage.

When a borrower pays discount points, they are effectively increasing the lender's yield on the loan. This occurs because the upfront payment enhances the lender's profit margin over the life of the loan. In return for paying these points, the borrower usually receives a reduced interest rate, meaning they can save on monthly payments.

While some might consider that discount points increase closing costs, the more significant aspect is how they enable the borrower to lower their effective interest rate, which can lead to substantial savings over time. By doing this, discount points impact the overall financial characteristics of the mortgage, benefiting both the lender through increased yield and the borrower by allowing for lower long-term interest costs.