Points seem like a good idea, after all, the interest rate is lowered. But if you don’t have cash on hand in advance, paying points can seem just out of reach. Do you need to pay points?

For most people, paying points just doesn’t make sense.

A point, often called a discount point or origination fee, is equal to one percent of the loan amount. Points are paid to the lender at the time of closing.

By paying points, you are buying down your interest rate. The more points you pay, the lower your interest rate. Lenders started offering points in the early 1980’s when mortgage rates were 15%. The housing market just went dead as people were unable to afford such high interest rates on mortgages.

To stimulate business, lenders offered discounted rates with fees attached, called discount points. Many sellers began to pay the points charged by the lender in order to sell their home. This gave the buyers an affordable mortgage and owners were able to get their homes off of the market.

But times have changed. Interest rates are no longer anywhere near 15% on mortgages — they are more like 7%. The need to fork out a ton of dough in order to get a lower rate isn’t really there for the average home buyer.

Let’s look at the numbers. For example, you find a 30 year fixed rate mortgage at 6.50% with two points. For the life of the loan, you have a fixed rate of 6.5%. But you will have to pay the points at closing. If the home you want to purchase is $192,000, you will have to find an extra $3,840 at the closing to cover the points.

Another lender is offering you a 7% interest rate on the same mortgage.

Which deal is better for you?

You put the standard 20% down on the loan. The monthly payment and interest payment for the 6.5% mortgage is $1,207. The 7% monthly payment increases to $1,270 per month. That’s a difference of $63 per month. If you divide the $3,840 by $63, you will find that it takes 61 months, or five years and one month, to recuperate your points in the form of a lower payment. This is your payback period.

You could put that $3,840 in the bank to earn interest. If your bank is paying three percent interest, you would earn approximately $10 per month. If you pay the points, you are loosing money that you could have made interest on. So, subtract $10 from the $63 savings. Now divide $53 into $3,840 and you will find that the payback period increases to 72 months, or six years.

So you have to stay in that home with that particular mortgage for six years to make back the money you pay in points. Most people won’t stay in a home for over six years today.

And with rising home costs, many home buyers don’t have the extra cash on hand to pay the down payment, closing and points. That’s why many lenders have started offering lower down payment mortgages — they understand how hard it is to save that money.

If the seller wants to pay points, that’s great and extremely rare in today’s market. If you aren’t positive that you will stay in the home long enough to recuperate the cost of your points, it would be best to choose the mortgage without points.