You’ve probably heard the term before or heard it referenced in a conversation between investors, but much like cap rates, “points” or “discount points” are one of those concepts that many people simply smile and nod along with and few really understand. Simply put, points are prepaid interest on a loan, which are equal to 1% of the loan amount. So, for a $100,000 loan, one point is equal to $1,000.

Most people are borrowers and thus their understanding of financing is generally limited to the nominal interest rate as a metric for analyzing the cost of financing. From the lender’s perspective the loan is an investment and if interest rates were the only tool they had to make a deal work, not many deals would get done. Real estate investors are looking for a specific return or yield on an investment and lenders are no different. There are many situations where the lender’s required yield and the borrower’s maximum monthly payments are incongruous. Discount points provide lenders with the ability to increase their yield (and reduce their risk) without affecting the borrower’s payment schedule or any balloon payments.

Basically, points lower a lender’s net investment in a loan thus allowing them to achieve a higher yield. Points can be charged as an actual fee at loan closing or their value/cost can be deducted from the actual loan amount. For example, if a lender charges 2 points on a $100,000 loan they can either charge the borrower $2,000 or only actually disburse $98,000 in funds. This increases the lender’s yield because their still receiving payments based on a $100,000 loan and their risk is reduced because the buyer has actually prepaid part of the loan or less actual money has been provided.