Pay more now for a chance to save much more later? That's the idea behind paying "points" on a mortgage loan. But it doesn't necessarily make sense for every homeowner.
Mortgage points provide an opportunity for borrowers to lower their monthly mortgage payments by paying a lump sum at a loan's closing in exchange for a lower mortgage interest rate over the course of a loan.
Mortgage points are a smart option for borrowers who plan to stay in the same mortgage and not refinance for a relatively long period of time. But points are not recommended for borrowers who are likely to relocate or refinance in the not-so-distant future.
Borrowers pay points in order to lower their mortgage interest rates by a certain amount. The cost of one point is equal to one percent of the mortgage amount. In the case of a 30-year fixed-rate mortgage, paying one point will typically lower your interest rate by somewhere around one eighth of a percent, according to Tim Dwyer, chief executive officer of Entitle Direct, a title insurance company.
So if borrower A paid one point on a $200,000 mortgage with what would have been a 4 percent interest rate, she would lower her interest rate to 3.875 percent (4 percent -- 1/8th percent) for the cost of $2,000.
A good way of looking at points is to view them as an investment that "yields a return for the longer you stay in your house," mortgage expert Jack Guttentag writes.
If Borrower A stays in the same mortgage for only a few years before selling her home or refinancing, she may end up not saving enough in monthly payments to justify paying the $2,000 upfront. But if she stays in the mortgage for a longer period of time, she eventually breaks even on her investment and enjoys saving money every month from there on out.
"If the points are reasonable, I want to pay that upfront and enjoy the interest rate savings over 10 years because I know I'm not going to refinance," Dwyer says. But if "you're a young couple" and "you know you're going to have more babies, you know you're going to be moving out," then you should avoid paying points.
Banks may offer 10 or more point combinations on any given loan, Guttentag writes, and borrowers often don't end up selecting the option that aligns most with their interests, simply out of ignorance. You can use a point calculator to find out how long it would take to break even using different point combinations.
In a perfect world, borrowers would pay points only if it benefited them in the long run. But, in fact, many borrowers pay points out of necessity. Why?
Lenders will only allow borrowers' monthly mortgage payments to equal up to a certain percentage of their monthly income. Often they will only approve loans for borrowers whose monthly mortgage payments would not exceed 28 percent of a borrower's monthly income.
Paying points allows a borrower who otherwise wouldn't qualify for a loan because of income limitations to lower his or her monthly payment to the extent that the bank is willing to make the loan.
Some banks offer "negative points," a rebate paid by lenders toward a borrower's closing costs. "Negative points" lower closing costs for a mortgage, but raise its monthly interest rate. They can be a good option for borrowers who are hard-pressed to cover closing costs with zero points or who intend on moving or refinancing in a few years.
Follow Teke Wiggin on Twitter (@tkwiggin), follow @AOLRealEstate, or connect with AOL Real Estate on Facebook.
Mortgage Jargon in Simple Terms
Real Estate Terms and What They Mean
Don't Be Surprised by Expenses of Homeownship
More on AOL Real Estate:
Find out how to calculate mortgage payments.
Find homes for sale in your area.
Find foreclosures in your area.
See celebrity real estate.