When you’re starting the process of applying for a mortgage loan, there are a lot of things to focus on, including the interest rate, fees, and whether you want a fixed rate or adjustable loan. But one option on the table that may save some borrowers a lot of money is buying down the rate.
Called “Discount Points,” it’s possible to essentially purchase a rate discount, or “buy down” by paying extra fees up front at the time of the loan closing.
Typically, a Discount Point, or just “point,” is equal to 1% of the mortgage amount, or $3,000 for a $300,000 loan, etc. The benefit to the consumer, of course, is that a lower rate equals lower monthly payments, ostensibly saving them a lot of money over the course of the loan. Another way to think about it is that you’re prepaying some of the interest of the loan up front in order to lower the interest payments over the remaining monthly payment schedule.
Just how much will it save you? The amount of the interest rate decrease varies widely depending on the lender, the loan program, and even the applicant. But to give a hypothetical example, some people may see a .25% (a quarter of a percent) reduction in the interest rate for every point they pay, so an interest rate of 6% (just for illustration purposes) would then be 5.75% after paying one Discount Point.
It’s important to note that these fees don’t ever go to the mortgage broker or loan consultant, but directly to the lender for the rate adjustment.
But the math on shelling out cash up front to pay discount points doesn’t always come out in the borrower’s favor. For instance if they are going to refinance or sell the home within a few years.
How can you tell if you should buy down your rate?
When a client comes to us, we’ll always present their best loan options, and that often includes buying down the rate. But the first thing we’ll do is sit down with them and calculate their break-even period, which is the date at which the savings from having lower monthly payments surpass the amount they paid up-front to buy the rate down.
For example, let’s say our hypothetical borrower was taking out a $500,000 loan and wanted to pay one point ($5,000) to lower the interest rate, in this case from 6.25% to 5.875%.
At 6.25%, their monthly payment was $2,604.17 on that loan, but at a rate of 5.875%, the payment would be only $2447.92.
That’s a monthly savings of $156.25, which sounds great, but we paid $5,000 up-front to get that savings.
So if we divide $5,000 by $156.25, we’ll find that it takes about 32 months for the savings to surpass the up-front fee – the break-even period.
Why is it so important to look at your break-even period? While most loans are amortized (meaning the payment schedule to pay the loan off to $0) over 30 years, the average homeowner goes through several loans in that period. In fact, in California, the average borrower sells their home and buys a new one every 7-10 years. Even refinancing, such as to take advantage of a lower rate or to take equity out of the home, will cause the amortization schedule to reset.
So if you aren’t planning on staying in the home – and the loan – for more than 32 months (in this illustration), then it won’t make financial sense to buy down the rate. However, if you have a great low-interest loan and plan on being in the home a long time, a rate buy down can really help you save money well past that break even period, saving you thousands or even tens of thousands of dollars in the long run.
Other considerations for paying points to buy down your rate:
We’ve been using the examples of paying points for 30-year, fixed rate loans, but how about buy-downs for adjustable rate loans? Typically, the option is available with most adjustable loan programs, with the savings usually occurring in the initial fixed period of the loan (5-year fixed rate for a 5/1 ARM loan), so you’ll want to make sure your break even period comes before that expires.
Check with your CPA or tax preparer, because paying points may offer you a tax break. Points you pay on your mortgage may be tax deductible in the year you signed the loan, since points are basically just pre-paid interest and mortgage interest is tax deductible. But, again, check with your tax professional.
If you’re buying a new home, sometimes the home builder will offer to pay point(s) on your mortgage as an incentive.
That also might be the case with sales of existing homes between a private buyer and seller, with the seller agreeing to pay a point for the buyer as part of the negotiated deal.
However, there may be limits to “third party” contributions in real estate transactions according to the specific lender, so we’ll review guidelines with you and present you all of your options.
You also can’t just keep buying down the rate until it gets to 0% or ridiculously low, as each lender will have their own restrictions, as well as QM rules that may prohibit excessive buy downs.
Your rate down buy down will show in the loan’s APR (annual percentage rate), a disclosure of the true cost and fees associated with the loan. You’ll see the point(s) or rate buy down you paid on the line-item breakdown.
Should you pay points to buy down your mortgage interest rate? It’s an option that potentially could save you significant money, but one that shouldn’t be taken lightly. Consult your CPA, do some strategizing about your financial situation and how long you plan on being in the loan, and come sit down with us to get a clear picture of all your loan options.