How Much Does It Cost to Buy Down a Mortgage Rate?

A mortgage rate buydown offers borrowers a way to reduce the interest rate on their home loan. This financial strategy involves an upfront payment made at the time of closing. This article explains the mechanics of mortgage rate buydowns and outlines the factors that influence their pricing.

Understanding Mortgage Rate Buydowns

Mortgage rate buydowns center around “points,” which are fees paid directly to a lender to secure a lower interest rate. A single point typically equals one percent of the total loan amount. For instance, on a $300,000 mortgage, one point would cost $3,000. These points are essentially prepaid interest, allowing a borrower to decrease their interest rate over the life of the loan.

There are two main types of points: origination points and discount points. Origination points are fees for processing the loan. Discount points are specifically used to lower the interest rate, generally reducing it by approximately 0.25%. This exact reduction can vary by lender and market conditions. Both types of points are included in the closing costs.

Calculating Permanent Buydown Costs

The cost of a permanent buydown is calculated directly using mortgage points. One point typically equals one percent of the loan amount, making the dollar cost straightforward. For example, if a borrower takes out a $400,000 mortgage and wants to purchase one point, the cost would be $4,000. This payment is made at closing, becoming part of the overall closing costs.

Each point purchased incrementally reduces the interest rate for the entire duration of the loan. While a common reduction is 0.25% per point, lenders set their own frameworks, and the exact reduction can range from 0.125% to 0.25% per point. To illustrate, if a $300,000 loan has an initial interest rate of 6.0% and the borrower buys one point for $3,000, the rate might drop to 5.75%. Lenders often cap the number of points that can be purchased, typically around three to four points.

The long-term savings from a permanent buydown can be substantial, but calculating the break-even point is important. This involves dividing the upfront cost of the points by the monthly savings from the reduced interest rate. For example, if $3,000 is paid to reduce the monthly payment by $48, the break-even point would be around 63 months, or just over five years. This calculation helps determine if the upfront investment is worthwhile based on how long the borrower plans to keep the mortgage.

Calculating Temporary Buydown Costs

Temporary buydowns, such as 2-1 or 3-2-1 buydowns, differ significantly from permanent buydowns. They do not involve traditional points to permanently lower the rate. Instead, an upfront sum of money is placed into an escrow account, which is then used to subsidize the borrower’s mortgage payments for a set period, typically one to three years. This arrangement provides a reduced interest rate for the initial years of the loan.

In a 2-1 buydown, the interest rate is reduced by 2% for the first year and 1% for the second year. For example, if the original note rate is 6%, the borrower would pay based on 4% in the first year and 5% in the second year, before the rate reverts to 6% in the third year. A 3-2-1 buydown extends this concept over three years, reducing the rate by 3% in the first year, 2% in the second, and 1% in the third. The total cost is the sum of these interest rate reductions over the buydown period.

The calculation involves determining the difference between the full monthly principal and interest payment at the original rate and the temporarily reduced payment for each month. These monthly differences are then summed for the total cost, which is deposited into the escrow account at closing. Funds from this escrow account are drawn monthly to cover the gap between the borrower’s reduced payment and the actual payment due to the lender. Borrowers must be approved for the mortgage at the full, unsubsidized interest rate, ensuring they can afford the payments once the buydown period ends.

Factors Influencing Buydown Pricing

The price of buying down a mortgage rate fluctuates based on market and individual factors. Current market interest rates significantly influence the cost of points. Lenders also have varying pricing structures, so comparing offers is important. The specific loan type can influence pricing; conventional loans generally allow points, while government-backed loans (FHA, VA) may have different rules.

The loan amount directly impacts the dollar cost of points because points are calculated as a percentage of the loan. A larger loan amount results in a higher dollar cost for the same number of points. Finally, the desired rate reduction directly affects the cost, as a greater reduction in the interest rate requires purchasing more points, thereby increasing the upfront expense.