If you've ever bought or sold a home, chances are good that you've come face-to-face with "discount points", a fee charged to either the buyer, the seller, or both, by mortgage lenders. What are "points" and how do they affect a real estate transaction?

"Discount points", originally created in the 1940's, served a narrow and specific purpose. When the Federal Housing Administration first began offering "FHA" loans, a lower interest rate was offered than that available on "conventional" loans. To compensate for these lower rates, a system was created in which one discount point was equal to 1/8% interest on a mortgage, or one percent of the loan amount.

If interest on an FHA loan was 5 3/4%, when 6% could be charged on a conventional loan, the lender would be short two-eighths of one percent interest on that loan. To compensate for the difference, an up-front fee of two discount points (2/8 of 1%) was charged to make up the difference.

Discount points today are charged on many different mortgage loans, including FHA, VA and Conventional. Points are charged to increase the lenders "yield" on a mortgage. Each point still equals 1% of the mortgage amount. Because a point increases the lenders' yield in small increments, 1/8% at a time, it is used to compensate for daily fluctuations in the money market, without the need for daily interest rate changes. Without points, lenders would be forced to change interest rates constantly to find an acceptable market level.

Who pays the discount points? Payment is often negotiable between buyers and sellers, but must be paid by the sellers on some loans. Point quotations can be "locked-in" for a period of time when obtaining a loan. Ask your agent to explain points in more detail.