How Much Can You Buy Down an Interest Rate?

A mortgage interest rate buy-down involves paying an upfront fee to reduce the interest rate on a loan. This strategy aims to lower monthly mortgage payments and decrease the total interest paid over the life of the loan, making homeownership more affordable.

Understanding Discount Points

The primary way an interest rate is bought down is through the purchase of “discount points.” A discount point represents a fee paid directly to the lender at the time of loan closing. Each discount point typically costs 1% of the total loan amount. For example, on a $300,000 mortgage, one discount point would cost $3,000.

These points are essentially prepaid interest, and in exchange for this upfront payment, the lender offers a lower interest rate on the loan. The exact reduction in the interest rate per point varies, but it commonly ranges from 0.125% to 0.25% for each point purchased. While one point often reduces the rate by 0.25%, this is not a fixed rule and depends on market conditions, the specific lender, and the type of loan product.

Factors Determining the Maximum Buy-Down

Several factors limit how much an interest rate can be bought down, including external constraints set by lenders and loan programs, as well as the borrower’s financial capacity. Lenders typically impose caps on the number of discount points a borrower can purchase, often limiting them to a range, such as 2% to 3% of the loan amount, though some may allow up to four points. These limits are influenced by lender policies and risk management considerations.

Loan programs also have specific rules regarding discount points. For instance, government-backed loans like FHA and VA loans have regulations concerning allowable fees and maximum points. A key constraint is the borrower’s available cash. Additionally, lenders usually maintain an interest rate floor, meaning the rate cannot be reduced below a certain minimum, regardless of the number of points paid.

Calculating the Financial Impact

Understanding the financial implications of buying down an interest rate involves calculating the upfront cost, the resulting monthly savings, and the time it takes to recoup the initial investment. To determine the total upfront cost of points, one multiplies the number of points by 1% of the loan amount. For example, on a $300,000 loan, two points would cost $6,000.

The next step is to calculate the reduction in the monthly mortgage payment due to the lower interest rate by comparing the principal and interest payment at the original rate versus the reduced rate. The break-even point, which indicates how long it takes for the monthly savings to offset the upfront cost of the points, is found by dividing the total cost of the points by the monthly savings. For instance, if points cost $6,000 and save $100 per month, the break-even point would be 60 months, or five years. Over the entire loan term, these monthly savings can accumulate into substantial total interest savings.

Different Buy-Down Structures

Beyond the permanent interest rate reduction achieved through discount points, there are also temporary buy-down structures. A permanent buy-down involves paying points to secure a lower interest rate for the entire life of the loan. This means the reduced rate remains constant from the loan’s inception until it is paid off or refinanced.

Temporary buy-downs, such as a 2-1 or 3-2-1 buy-down, offer an interest rate reduction for a specific period at the beginning of the loan term. For example, a 2-1 buy-down reduces the interest rate by 2% in the first year and 1% in the second year, then reverts to the original note rate. A 3-2-1 buy-down reduces the rate by 3% in the first year, 2% in the second, and 1% in the third. These temporary reductions are typically funded by a third party, such as the seller, builder, or lender, with funds held in an escrow account to subsidize initial lower payments.