How Much Does It Cost to Buy Down a 1 Percent Rate?

An interest rate buydown offers a method for individuals to obtain a lower mortgage interest rate by paying an upfront fee. This strategy involves a borrower providing additional funds at the beginning of the loan term for reduced interest payments over the life of the mortgage. The primary goal is to decrease the overall cost of borrowing by securing a more favorable interest rate.

Understanding Interest Rate Buydowns

An interest rate buydown centers on “discount points.” A discount point is a fee paid to the lender to lower the mortgage interest rate. Each point costs 1% of the total loan amount. For instance, on a $300,000 mortgage, one discount point costs $3,000.

These points are a form of prepaid interest, enabling a borrower to secure a permanently reduced interest rate for the loan’s duration. Paying this upfront cost aims to achieve lower monthly mortgage payments. The relationship between points paid and interest rate reduction varies among lenders.

Calculating the Cost for a One Percent Reduction

To reduce your interest rate by one percent, understand the relationship between discount points and rate reductions. While this relationship varies by lender and market conditions, one discount point typically lowers the interest rate by approximately 0.25%. This means achieving a one percent reduction requires purchasing four discount points.

For example, on a $400,000 mortgage, a one percent rate reduction requires four points. Since each point costs 1% of the loan amount, four points equal 4% of $400,000, totaling $16,000. For a $250,000 loan, a one percent rate reduction costs $10,000 (four points at $2,500 each). The cost is directly proportional to the loan amount and the specific point-to-rate reduction ratio offered by the lender.

Factors Influencing Buydown Costs

Several elements impact the cost of buying down an interest rate. The loan amount directly affects the total dollar cost of points, as each point is a percentage of the principal. A larger mortgage naturally incurs a higher total expense for the same number of points. For instance, four points on a $500,000 loan will cost more than four points on a $300,000 loan.

Lender pricing also plays a significant role, as different financial institutions may offer varying point-to-rate reduction ratios. While 0.25% per point is common, some lenders might offer a smaller reduction, such as 0.125% per point, which would necessitate purchasing more points to achieve the same one percent decrease. Market conditions, including prevailing interest rates and economic outlooks, can also influence the pricing of discount points. The type of mortgage, such as a fixed-rate loan, typically has different buydown structures compared to adjustable-rate mortgages, where the rate reduction from points might only apply to the initial fixed period.

Navigating the Buydown Process

Engaging in a discussion with your prospective lender is the initial step to explore buydown options. Inquiring about the available point-to-rate reduction ratios and their corresponding costs helps clarify the potential financial commitment.

Once a loan application is submitted, the costs associated with discount points are disclosed on the Loan Estimate (LE), a document provided within three business days of application. On the Loan Estimate, discount points are typically listed in Section A, often under “Origination Charges” or specifically as “Points” or “Prepaid Interest.” This section details the fees charged by the lender that cannot be shopped for.

The final costs, including any discount points, are then presented on the Closing Disclosure (CD), which borrowers receive at least three business days before closing. The CD lists discount points in Section A, contributing to the total origination charges. The payment for these points is typically made as a one-time lump sum at the loan closing.

Key Considerations Before Buying Down

Before committing to a buydown, calculate the break-even point. This determines how long it will take for the savings from a lower interest rate to offset the upfront cost of the discount points. A simple method involves dividing the total cost of the points by the monthly savings on the mortgage payment. For instance, if points cost $8,000 and result in $100 monthly savings, the break-even point would be 80 months, or approximately 6.7 years.

The length of time a borrower plans to keep the mortgage or remain in the home significantly impacts the value of a buydown. If the loan is paid off or refinanced before reaching the break-even point, the upfront investment in points may not be fully recouped. Individuals should also consider alternative uses for the funds. Evaluating whether the cash could provide a greater return or serve a more immediate financial need, such as increasing a down payment or bolstering an emergency fund, is an important part of the decision-making process.