Discount points are fees paid upfront to lenders at closing in exchange for a lower interest rate on a mortgage. Each point is equivalent to 1% of the loan amount and is used to lower the borrower's interest rate. By paying points upfront, the borrower effectively means that the lender is receiving a higher yield on the loan over its lifetime because the combination of the lower interest payments and the initial cash payment increases the lender’s overall return.
The connection between discount points and the effective yield involves the lender's perspective. Although the borrower pays more initially, the lower interest rate can mean significant savings in interest payments over the term of the loan. However, the initial payment from the borrower (the points) provides immediate income to the lender, which enhances the effective yield on the loan.
In essence, when discount points are paid, they do not just act as a method for the borrower to reduce monthly payments but also significantly increase the lender's yield, making the amount received from the loan more favorable. This is why the effect of discount points leads to a higher effective yield for the lender.