When you shop for a loan, you should look at more than the interest rate alone. Mortgage loans usually require the payment of discount points in addition to the various fees associated with originating the loan. These points are additional interest paid at the time the loan is closed and can add substantially to the cost of the loan. When the lender quotes an interest rate, it is usually expressed as “eight percent plus two points.”

Each point is a charge of 1 % of the amount of the loan. For example, if you are seeking a loan of $98,000, one point would cost you $980. At the closing, the lender will advance only $97,020 ($98,000 less $980), and you must make up the difference. Alternatively, you can write a check to the lender for $980 and the lender will advance the full amount. There is no real difference, except for tax purposes. If you write a check for the points, you should be entitled to an immediate tax deduction for the points, provided you are getting the mortgage to buy a principal residence (refinancing will not qualify) and that the points are a customary charge in your local area.

In either case your loan payments are based on the full $98,000, and that is how much principal you will eventually pay back to the lender. This means you must come up with additional cash to buy the home or to refinance an existing loan. In some cases of refinanced loans, the lender will allow you to borrow the points and pay them back as part of the monthly payments. You should take this expense into account when deciding whether or not to refinance.

Within the loan market, there probably will be a vanity of combinations of interest rates and points. The same lender may offer different combinations. If you are short of cash, you should look for loans with no or few discount points. However, these loans will probably carry higher interest rates. If you are having trouble qualifying for the loan, you may wish to pay more points for a lower interest rate. Many lenders allow you to pay additional points to reduce the interest rate further. These types of loans are called buy-downs. You may even try to negotiate with the seller of the home to pay some or all of the points.

If you are indifferent as to whether you pay the cost of the loan in the form of points or a higher interest rate, you will want to compare loan offerings on the basis of actual cost. When the points are factored into the cost of the loan, the rate is called the effective interest rate. The lender’s disclosure of the true cost of the loan should indicate the annual percentage rate (APR). This is the effective inter­est rate assuming you keep the loan until it is paid off. As a rule of thumb, each discount point adds approximately one-eighth of one percentage point to the interest rate. This can be seen by referring to the chart below.

As the chart indicates, a loan at 10% interest and four points has the same effective interest rate as one at 10.5% interest and no points. These comparisons are for loans held for the entire 30 years to maturity. If the loan is held for a shorter time, the effective rate will be higher, depending on how long the loan is outstanding. Differences are not too great for loans that go beyond ten years, but they are for loans paid much earlier.

For example, a 10% loan with two points that is pre­paid in one year has an effective rate of 12% because the two points are all returned in just one year; so the two points can be added to the 10% annual interest rate. If that loan is outstanding for two years, the two points are spread over two years; so the annual interest rate is about 11% (10% interest plus one point each year). As you can see, the idea is to spread the points over the life of the loan. However, points are not spread evenly owing to a complicated computation of the effective interest rate.