What are "points" on a loan?

When you're shopping for a loan you might hear the lender talk about "paying points" or "buying down the interest rate." What does that mean?

A “point” is equal to one percent of the loan amount. So on a mortgage of $150,000, for example, one point would be $1,500; three points would be $4,500. Most lenders give you the option of paying points up front (at closing) in order to get a cheaper interest rate.

Should you do it? It depends on how long you plan to stay in the home – and whether you have enough cash to pay this chunk of interest up front.

As an example, let's say you are borrowing $150,000 to buy a house. You are given the choice of

   an interest rate of 4.50 percent and pay 0 points at closing   OR

   an interest rate of 4.00 percent and pay 3 points (an extra $4,500) at closing

What should you do?  

The difference in the monthly payment would be $44.  If you take the first option you will pay $760 a month in principal and interest. If you pay the points and buy down the interest rate your monthly payment will be $716.

You would have to stay in the house 8 years and 5 months for that extra $44 a month to add up to $4,500 and pay back your upfront investment. After that, you would be saving $44 a month.

So is it worth it? If you plan on staying in the house more than 10 or 12 years, yes. If you stay in the house the entire period of the 30-year loan you will save $11,396 in interest (the remaining 21 years and 7 months at $44 a month).

But if you only plan in living in the house a few years you will not make back the money you paid up front for the lower rate.

Remember -- YOU are the customer. You can just say no. Don't be pushed into paying points if you're not comfortable with the idea.