What are points on a mortgage?
A good explanation from the Wikipedia article on Mortgage Points:
Points, sometimes also called a "discount point", are a form of pre-paid interest. One point equals one percent of the loan amount. By charging a borrower points, a lender effectively increases the yield on the loan above the amount of the stated interest rate. Borrowers can offer to pay a lender points as a method to reduce the interest rate on the loan, thus obtaining a lower monthly payment in exchange for this up-front payment. For each point purchased, the loan rate is typically reduced by 1/8% (0.125).
To know whether or not paying points for a mortgage is a good idea for you, you can use one of many online calculators. I like the Mortgage Professor's website (see calculators 10-11).
There's a payback period associated with this prepayment. If you sell or refinance your mortgage before the payback period, you lose money on the investment of points. If you keep your mortgage past the payback period, you save money from the lower interest rate.
Points are pre-paid interest. Effectively the lender is saying that they will give you a lower annual rate if you'll pay them a lump sum up front. It varies from lender to lender, but generally paying points is a good deal only if you plan to live in the house (and not refinance) for at least 5-7 years.
Many lenders will use points to make their rates look lower than those of other lenders. For instance, one bank might have a rate that is .50% lower than another, but you'll have to pay a couple thousand dollars extra at closing to get that rate, which is why whenever you compare rates at banks, you always need to consider how many points they are "baking in" to that rate as well as the rate itself.