When discussing mortgage loan points, the lender isn't talking about the points that make up your credit score. He's giving you the option to get a better deal on the loan. But in some cases, it's not necessary or beneficial to you to pay points, so you should proceed with caution before you agree to this arrangement. Always look at the mortgage offer closely to check if points are required before you commit to the loan.
What Are Points
A point is equal to 1 percent of the amount you want to borrow to purchase your new home. So for instance, if you have a $200,000 loan and choose to pay a point on your mortgage you have to pay $2,000. Borrowers pay points to get better rates on mortgages—paying one point commonly reduces your interest rate by a quarter of a percent. So instead of paying 6 percent, you'll pay 5.75 percent on the loan due to paying one point.
Look at a hypothetical loan to understand how paying a point can benefit you. Run the terms through an online mortgage calculator. If you borrow $200,000 for 30 years at 6 percent you'll pay a total of $231,676.38 in interest with a payment of $1,199.10 per month. But if you get that 5.75 percent loan you'll pay $220,172.46 in interest with a payment of $1,167.15 per month. If you stay in the same home and loan for all 30 years you'll save over $11,500 in interest, which eclipses the $2,000 you paid for the mortgage point.
One of the main reasons why it's important to think over the decision to pay points is that you have to pay the money now. The lender does not build the cost of the points into your loan—you have to pay them at closing. Gathering the cash before closing can prove a challenge in some cases. Also you don't get the money you gave to the lender for those points back, even if you end up leaving the home or refinancing soon after you close.
If you know ahead of time that you want to to stay in the home for only a short period (a few years or less), it's probably not a smart idea to buy points. Again, points only benefit people who have long-term plans to live in the same home. In this case, instead of paying for mortgage points at closing, you may want to put more money toward your down payment. The reduction in principal also saves you interest. Additionally, if the mortgage lender requires you to pay mortgage insurance (which is an insurance policy that protects the lender in case of default), you might be able to eliminate or lower that mortgage insurance premium by paying a larger down payment.