If you are like most homebuyers, you want the lowest possible interest rate on your mortgage. It makes sense because who wants to pay too much for their loan? But sometimes that lower rate comes at a cost. You may have to buy down the rate, otherwise known as paying points.
What this means is you pay a fee at the closing to get the lower rate. You may see it called ‘discount points,’ or ‘origination fee.’ Either way, it’s a percentage of your loan amount. For example, one point equals 1% of your loan amount. On a $200,000 loan, one point would cost you $2,000. You should see the fee on your loan estimate on its own line so that you can see what the lower rate will cost you.
Should You Buy Down the Interest Rate?
Here’s the bigger question – should you buy down the interest rate? At what point does it make sense to pay now for a lower rate for the term of your loan? For this answer, you need to determine your break-even point. This is the point that you pay off the fee with the savings of the lower rate and start reaping the monthly savings.
Let’s say you are able to pay one point on a $200,000 loan and will save $50 per month with the lower rate. That one point will cost you $2,000. Your break-even point would be:
$2,000/$50 = 40 months
It would take you 3 years and 6 months to start benefitting from the lower rate. Now that you know the break-even point, you can decide if it makes sense. Let’s say, for example, that you will move within the next 5 years. It may not make sense to pay that money upfront then. What if you end up moving sooner than 5 years? You just wasted money on the discount points and you don’t benefit from it.
Buying Down Your Rate is Prepaid Interest
You might wonder just what buying down the interest rate does for the lender. Why would they offer this? You can look at it this way – it’s prepaid interest for the lender. In exchange for the lower rate, they charge you points. Those points are then the prepaid interest. If they charged you the higher interest rate, they would have eventually made the same amount over the life of the loan. Because you paid the fee upfront, though, they don’t have to charge as high of an interest rate. The lender still walks away with the same profit, just at different times.
Is One Point Worth It?
Just how much you save with each point you pay depends on the lender. On average, you can expect to save 0.25% per point that you pay. This may vary by lender as they base it on your qualifying factors as well. You may find lenders that offer a greater discount for one point and those that charge more for that 0.25% decrease in your rate.
It comes down to you doing the math. Don’t focus on a specific interest rate. Instead, look at the big picture. What will the loan cost you over its lifetime? If you focus on the rate alone, you might end up paying more than necessary. A higher rate doesn’t mean you pay more for the loan. If you overpay upfront on the loan, you may pay more for the loan over its lifetime. Instead, look at the total cost of the loan and its APR or annual percentage rate.
Rather than fixating on your interest rate, know what you want to pay for a loan. You can then set out to get that cost, whether it means a lower or higher rate. It is possible to buy down your rate, but you want to make sure that it makes sense before doing so. Check with several lenders too so that you can make sure you are getting the best deal available to you.