How Much Does It Cost to Buy Down an Interest Rate?

Navigating the complexities of mortgage interest rates is a common concern for many individuals seeking to finance a home. Mortgage interest directly impacts the size of monthly payments and the total cost accumulated over the loan’s duration. Understanding strategies to manage these costs can be beneficial for borrowers. This article explores a method known as an interest rate buydown, which can influence the financial burden of a home loan.

Defining Interest Rate Buydowns

An interest rate buydown involves paying an upfront fee to a lender for a reduced mortgage interest rate. Also known as “buying down the rate” or using “discount points,” these fees act as prepaid interest, lowering the rate for the loan’s entire life. This initial cost aims to reduce the total interest paid over the mortgage term.

Mortgage points come in two forms: discount points and origination points. Discount points reduce the interest rate, while origination points are fees paid to the lender for processing the loan. Though both typically equal one percent of the loan amount, only discount points lower the interest rate.

Calculating Buydown Costs

The cost of buying down an interest rate is tied to “points.” A single mortgage point equals one percent of the total loan amount. For instance, on a $300,000 mortgage, one point costs $3,000. If a borrower purchases two points on the same loan, the upfront cost doubles to $6,000.

Lenders determine how much each point reduces the interest rate, with a common reduction between 0.125% and 0.25% per point. For example, a $400,000 mortgage at 6.5% without points could drop to 6.25% by purchasing one point for $4,000. The number of points available, typically from a fraction to three, and the rate reduction per point vary by lender and market conditions.

Determining Your Break-Even Point

Evaluating the financial benefit of an interest rate buydown involves calculating the break-even point. This represents the duration, in months, it takes for monthly savings from a lower interest rate to equal the initial upfront cost paid for points. This requires calculating the difference in monthly payments between the original and bought-down rates.

For example, a $250,000 mortgage at 3.5% has a monthly payment of approximately $1,123. If one discount point costs $2,500 and lowers the rate to 3.25%, the new monthly payment might be around $1,088, saving about $35 monthly. The break-even point is found by dividing the total upfront buydown cost by the monthly savings. In this example, $2,500 divided by $35 equals approximately 71 months, or nearly six years, to recoup the initial investment.

Factors Influencing Your Decision

Several financial considerations influence whether purchasing points for a mortgage buydown is suitable. The loan term impacts total interest savings. A longer mortgage, like a 30-year fixed loan, accrues more interest, making cumulative savings from a lower rate more substantial.

A homeowner’s planned occupancy is another factor. If you expect to sell or refinance before the break-even point, the upfront cost may not be recovered, diminishing its financial advantage. Additionally, buying down an interest rate requires an upfront cash payment at closing. This necessitates sufficient liquid funds, as these costs are in addition to the down payment and other closing expenses.

Points paid for a primary residence mortgage may be tax-deductible as qualified residence interest in the year they are paid, if certain IRS criteria are met. These include the loan being secured by the main home, points being an established business practice, and the amount not exceeding typical charges. If the mortgage exceeds $750,000, limitations on deductible points may apply. For refinanced mortgages or loans on second homes, points generally must be deducted over the loan’s life.