Discount Points

1. Also known as points

2. Signify interest payments made at the beginning of the loan

3. Availing 1 discount point means paying 1% of the loan at the time of closing
the loan

4. In exchange, the lender reduces the interest rate on the loan

5. Trade off

No Discount Points Discount Points

No upfront expense Upfront expense
No reduction in interest Reduced interest
rate rate

6. Should we pay discount points?

Depends on how long we intend to hold the loan. If we want to prepay the
loan, the EAR will be higher.

7. Discount points should be paid if we intend to hold the loan long enough to:

a. Offset the upfront expense

b. Avail the benefit of lower interest rate

8. Example:

12% loan with no discount points 2 Discount Points with 11.5%

Time = 30 years = 360 months interest rate
Amount = $100,000 Time = 30 years = 360 months
Amount = $100,000
Monthly Interest Rate = 12% / 12 = Monthly Interest Rate = 11.5% / 12 =
1% 0.9583%
N = 360 N = 360
PV = $100,000 PV = $100,000
Compute PMT = - $1,028.61 Compute PMT = - $990.2609
EAR = (1 + .01)12 – 1 = 0.1268 =
12.68% The interest rate is applied to
$100,000 but we get to use only
$98,000 (because we pay 2 discount
points, i.e.; $2,000 upfront)
Therefore,
1
 PMT = - $990.2609
N = 360
PV = 98,000
Compute I = 0.9803% p.m.
EAR = (1 + 0.009803)12 – 1 = 0.1242
= 12.42%
Conclusion: If we intend to hold the loan till its entire duration, paying
discount points is beneficial as it reduces the EAR from 12.68% to 12.42%

What would happen if we pay the discount points but then wish to prepay the
loan after 3 years?

1. We continue to make the loan installment of $990.2609 for 36 months.

2. Outstanding balance at the end of 36 months, i.e.; the balance
remaining for being paid in the next 324 months?
3. Time Line:

T= T = 36 T=
0 360
PV324 =
?
PMT = - $990.2609
N = 324
I = 11.5% / 12 = 0.9583
Compute PV324 = $98,633.7282

Let us review the position now:

1. Apart from the regular monthly payments, we will need to pay
$98,633.7282 at the end of 36 months. In time value terms, this
becomes our FV
2. Time Line:

T=0 T= T=
36 360
FV36 =
$98,633.7282

3. We make our monthly payments calculated on a loan amount of

$100,000 but we get to use only $98,000 at the moment. In time value
terms, this becomes our PV
4. So, what interest rate we end up paying?

2
 FV36 = - $98,633.7282
PV = $98,000
PMT = - $990.2609
N = 36
Compute I = 1.0254% p.m.

EAR = (1 + 0.010254)12 – 1 = 0.1302 = 13.02%

5. Conclusion: We should not prepay the loan in the 3rd year as the EAR is
higher than 12.68% (the alternative with no discount points)

6. Practice Question: How long should we hold the loan to make the
discount points beneficial?