If there was one aspect of a mortgage that you considered important, what would it be? Many borrowers say the interest rate. They want the lowest rate possible. It makes sense. Why pay more for a mortgage than necessary? If you have room for negotiation, you should take it. Sometimes, though, the better rate doesn’t come free. You have to pay for it. Here we look at the different ways to pay for a lower rate.
The Traditional Discount Point
The most common way to buy a better rate is with a discount point. Many lenders offer 1/8th off your rate for every point you pay. One point equals 1% of your loan amount. On a $300,000, one point equals $3,000. The more points you pay, the lower your interest rate.
Lenders are able to offer the lower rate because the points are prepaid interest. The lender makes the money upfront. This way they don’t wait while you make payments. Whether you should pay the points depends on your situation. We discuss the break-even point below.
What’s Your Break-Even Point?
Before you pay those discount points, figure out your break-even point. This is the point that you pay off the points. It is based on the monthly savings you reap from the lower rate. It’s a simple calculation:
Cost of the points/Monthly savings = Break-even point
Here’s a real example:
Points cost $3,000/$50 monthly savings = 60 months break-even point
This means it would take you 5 years to make up the cost of the point you paid. Now, think of your plans. Will you be at the home in 5 years? How much longer than 5 years will you be there? If you don’t see yourself there for much longer than 5 years, the point may not be worth it. It takes more capital up front. You may not be in the home long enough to see the savings.
The points we discussed thus far is permanent discount points. Now, there are temporary buy down points. We talk about them below.
A temporary buydown is points you pay to temporarily buy your rate down. You will see them written as 3-2-1 or even 2-1. In the first example, the interest rate will be 3 percent lower the first year. It will then be 2 percent and 1 percent lower respectively. After the third year, the rate equals the note rate.
Who benefits from this type of buydown? Borrowers who know their income will increase in time. It is also a good choice for borrowers that have a lot to purchase with a new home. First-time homebuyers often have nothing. They must buy furniture, appliances, and décor. This all costs money. If they have the chance to lower their rate 3% the first year, this can free up their money.
It is also a good option for borrowers buying a fixer-upper. Freeing up money for the first few years can make the changes more affordable. As the homeowner gets more established, they can afford a higher payment. There is less to pay for. Sometimes, income increases in that time as well. This can balance everything out.
Just like with a permanent buydown, you pay the prepaid interest upfront. On a 3-2-1, you pay 6% up front. This allows gives you to have the lower payments throughout the first three years. The total discount equals 6%.
It might not make sense to pay for a buydown upfront. If you can’t afford the higher payment, how can you afford the points? Often, the seller pays the buydown points. In some cases, builders pay them as well. This decreases the money you need at the closing and gives you the lower interest rate.
Should you Buy a Better Rate?
How do you know when you should buy a better rate? We already discussed the break-even point. This is the traditional method of determining the right answer. There are other ways as well:
- If you have more money than you need for a down payment, you can put it towards the rate. This applies to borrowers that have more than the minimum. For example, on an FHA loan, you need 3.5% down. If you have 6% available, you may consider buying the rate down. This allows you to get the lower interest for a few years or the life of the loan.
- If you refinance your loan, you may be able to roll the closing costs into the loan. This may include the points. If you have this option and will stay in the home, it may help you save money over the life of the loan.
- If you don’t want to refinance in the future, buying a low rate now helps. Refinancing costs money. Not every wants to do it. It could also be cheaper to buy the lower rate now. This helps if you know you will stay in the home for the long-term.
- If you know this is your “forever” home, you can minimize the amount of interest you pay. It may also help you pay the loan down faster. With lower payments, you may have more money to put towards the principal.
Buying a better rate is a personal decision. Look closely at your options. Then evaluate your situation. If you know this is a short-term purchase, buying the lower rate might not make sense. If this is a long-term purchase, though, look closely at your options. A lower rate can save you quite a bit of money over the long-term.
Check out your options with different lenders. Look at both buying down the rate and taking the quoted rate. Look at the long-term results of each option. Don’t forget your tax benefits, too. You may be able to deduct the interest you pay on your income taxes. Talk to your tax professional and your loan officer. Together you can decide which option works the best for your situation.