Loan Financing Costs: Discount Points, Prepayment Penalties & Fees

Instructor: Dante Tuton

Dante is an active realtor, has real estate licenses in three states and a master's degree in education.

Real estate professionals need to know the expenses involved in getting a loan to purchase a home. In this lesson, you will learn about the typical costs, fees, and calculations associated with obtaining a mortgage.

What is a Mortgage?

Buying a home is one of the largest and most important investment decisions your clients will make. Very few people purchase a home with cash and instead borrow money from a lending institution such as a bank, credit union, or finance company. It is important for agents to be knowledgeable about financing costs of home loans to provide quality service to their clients, especially when working as a buyer agent.

Financing a home involves taking out a mortgage, which is a voluntary lien or encumbrance on the real property of the borrower who can also be called a mortgagor. There are two parts to a mortgage:

  1. the promissory note, where the borrower signs this note pledging to repay the money over a specified period of time with interest, and
  2. a mortgage or deed of trust, which specifies the collateral used to secure the loan.

Therefore, a mortgage is a secured loan. If the borrower does not pay the agreed upon amount to the lender then the lender can take the property that was used as collateral through a process called foreclosure to recover the money lent.

Now that you have a basic understanding of a mortgage let's talk about costs associated with taking out a home loan.

What is Interest?

Interest is a charge for the use of money. A lender charges a percent of interest on the principal - the amount of money borrowed - over the time of the loan. Interest is adjusted up or down based on a certain economic standard such as the prime lending rate or the rate of return on government bonds.

The higher the interest rate the more it will cost to repay the loan. The interest rate the lender charges to the borrower is also determined by the credit worthiness of the borrower. If the lender deems the risk of not getting their money back from the borrower high, they may charge a higher interest rate or not lend the money at all.

Loan Origination Fees

Once the borrower is approved for the loan or deemed credit worthy, they will make an application for a mortgage. The processing of a mortgage application is called 'loan origination'. The rate of return or profit on the money borrowed is determined during this process.

The expenses associated with generating the loan are passed on to the borrower and called a loan origination fee. This charge is not prepaid interest and is usually collected at closing. The typical loan origination fee is 1 percent of the loan amount, which is called a point. But the fee can range from one to three points. For example, if the loan amount is $100,000 one point would cost the borrower $1,000 ($100,000 x 0.01) two points would be $2,000 ($100,000 x 0.02) and three points would be $3,000 ($100,000 x 0.03).

Discount Points

To increase their rate of return or profit on a loan, a lender may charge discount points. Discount points are prepaid interest and charged at closing. Remember a point is 1 percent of the amount being borrowed. These points make up a difference in the interest rate charged and the interest rate the lender requires to make the loan. If the lender is charging 3 points on an $80,000 loan, the cost to the borrower would be $2,400 ($80,000 x 0.03). Each point is one percent of the amount borrowed.

Do not confuse the amount borrowed with the purchase price of the home. To determine how many points are being charged on a loan, divide the total dollar amount of the points by the amount of the loan. For example, the loan amount is $325,000 and the charge for the points is $9,750, how many points is the lender charging? $9,750 / $325,000 = 0.03 (0.03 * 100), 3%, or 3 points.

Prepayment Penalty Fee

What if the borrower pays off the loan before the scheduled time on the mortgage? Doesn't this mean the lender will not make the money they calculated to make during the origination process? Yes, and the lender's profit on the loan goes down.

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