California Real Estate Practice Exam

When a borrower pays 2 discount points on a mortgage loan, what is true concerning the loan's rates?

1. The nominal rate will be higher than the APR

2. The APR will be lower than the nominal rate

3. The nominal rate will be lower than the APR

4. There is no difference between the nominal rate and the APR

The correct answer is: The nominal rate will be lower than the APR

When a borrower pays discount points on a mortgage loan, it is important to understand how this affects the loan's nominal interest rate and the annual percentage rate (APR). Discount points are prepaid interest, where one point is equal to 1% of the loan amount. By paying these points, the borrower effectively buys down the interest rate on the loan. The nominal rate, or the stated interest rate, does not take into account any costs or fees associated with obtaining the loan, such as discount points. The APR, on the other hand, is designed to give a broader perspective of the true cost of borrowing over the life of the loan, including not only the interest but also any fees and charges, such as discount points. In this case, if a borrower pays 2 discount points, the APR will reflect a lower effective interest rate because it spreads the initial cost of those points over the life of the loan in comparison to the nominal rate, which only shows the interest charged on the outstanding balance. Therefore, it is accurate to say that the nominal rate will be lower than the APR in this scenario, reinforcing that the additional costs associated with the borrowing are accounted for in the APR calculation.