Can You Permanently Buy Down an Interest Rate?

Many individuals exploring homeownership often encounter the concept of “buying down” an interest rate. This process typically involves an upfront payment made at the time of securing a mortgage loan. Understanding whether such a reduction in the interest rate is a permanent change and the financial mechanics behind it is important for prospective borrowers. This article aims to clarify the nature of these rate reductions and explain the practical implications involved.

Understanding Interest Rate Buy-Downs

An interest rate “buy-down” in the context of a mortgage refers to the borrower paying an upfront fee to the lender in exchange for a lower interest rate on their loan. These upfront fees are commonly known as “points” or “discount points.” Each point paid typically represents one percent of the total loan amount. For example, on a $300,000 mortgage, one point would cost $3,000.

Lenders offer these discount points as a way for borrowers to reduce their overall interest expense over the life of the loan. The specific reduction in the interest rate for each point paid can vary between lenders and market conditions, but it generally translates to a fraction of a percentage point, such as 0.125% to 0.25% per point. This payment effectively prepays a portion of the interest, leading to a lower contractual interest rate for the borrower.

The Permanence of Rate Reductions from Points

When a borrower pays discount points to reduce their interest rate, that lower rate is a permanent feature for the entire duration of that specific mortgage loan. This means the interest rate agreed upon, after applying the discount points, will remain fixed for the life of the loan, assuming it is a fixed-rate mortgage, unless the borrower refinances the loan or pays it off early. This stability provides predictability in monthly mortgage payments over many years.

It is important to distinguish this permanent reduction, achieved through borrower-paid discount points, from “temporary buy-downs.” Temporary buy-downs, such as 2-1 or 3-2-1 structures, are often subsidized by a third party, like the home seller or builder, or even the lender, for a limited initial period. For instance, a 2-1 buy-down might offer an interest rate two percentage points lower than the permanent rate for the first year, and one percentage point lower for the second year, before the rate adjusts to the higher, permanent rate for the remainder of the loan term.

Calculating the Financial Impact of Buying Points

Understanding the financial implications of buying points involves calculating the upfront cost, estimating monthly savings, and determining a “break-even point.” The upfront cost is straightforward: one point equals one percent of the loan amount. For a $400,000 mortgage, two points would cost $8,000. This cost is typically paid at closing and is itemized on the closing disclosure.

To estimate the monthly savings, one must compare the monthly principal and interest payment with and without the points. For example, on a $400,000 30-year fixed-rate mortgage at 7.0% interest, the monthly principal and interest payment is approximately $2,661. If paying two points reduces the rate to 6.75%, the payment drops to about $2,600, resulting in monthly savings of approximately $61. These savings accumulate over time, reducing the total interest paid over the life of the loan.

The “break-even point” is the number of months it takes for the accumulated monthly savings to equal the initial cost of the points. Using the previous example, with an $8,000 cost and $61 in monthly savings, the break-even point would be about 131 months, or approximately 10 years and 11 months ($8,000 / $61 ≈ 131.15). This calculation helps a borrower evaluate whether paying points makes financial sense based on how long they anticipate keeping the mortgage. If a borrower plans to sell or refinance before reaching the break-even point, the upfront cost of the points may not be recovered through interest savings.

Borrowers should consider the tax implications of paying points. For a mortgage to purchase or improve a principal residence, points are generally tax-deductible in the year paid, provided certain IRS conditions are met. These conditions include the loan being secured by the borrower’s main home and the points being customary in the area, which reduces the borrower’s taxable income and lowers the net cost of the points. For points paid on a refinance or home equity loan, they must be amortized and deducted over the life of the loan. These details are reported on Form 1098, and deductions are claimed on Schedule A.