Points are 1 percent of the loan or one hundred basis points of the loan. For example, if the loan is for $200,000, then one point is equal to $2,000. Lenders charge points to recover costs associated with lending, to increase the effective interest rate they are receiving, to provide for negotiating flexibility in a market where interest rates fluctuate, and to adjust for differences in risk between loans. Points are deducted directly from the loan amount at closing. In other words, if you have a $200,000 loan with two points (2 * $2,000), you will only receive $196,000 at closing—the mortgage broker will keep $4,000. However, you will have to pay back the full $200,000.

Some lenders offer mortgage loans with high contract interest rates and low points, while others offer the opposite. The borrower’s challenge is to choose the mortgage contract that minimizes the effective cost of borrowing. How do you differentiate between loans with different interest rates, different points, and different costs? One way to differentiate between loans is to calculate the effective interest rate (EIR) for each of your loan options; you will then be able to choose the loan that minimizes the effective interest rate.