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

When securing a mortgage, borrowers often seek ways to manage their long-term costs. One strategy involves reducing the interest rate on a home loan by paying an upfront fee. This financial decision, known as “buying down your interest rate,” can lead to lower monthly payments over the life of the loan. It presents a trade-off between immediate expenses and future savings, making it a consideration for many homebuyers.

Understanding Discount Points

Buying down an interest rate is accomplished through the purchase of “discount points.” These are fees paid directly to the mortgage lender at closing to secure a lower interest rate on the loan. Each discount point typically represents one percent of the total mortgage amount. For example, on a $300,000 loan, one discount point would cost $3,000. This upfront payment serves as a form of prepaid interest, reducing the overall interest rate applied to the loan.

Discount points differ from “origination points.” While both are fees paid at closing and usually equate to one percent of the loan amount, their purposes differ. Origination points are fees charged by the lender for processing and underwriting the loan, and they do not influence the interest rate. Discount points are specifically purchased to achieve a permanent reduction in the interest rate over the loan’s duration.

Calculating the Cost of Buying Down Your Rate

The cost of buying down your interest rate is directly tied to the loan amount and the number of discount points purchased. Each point costs one percent of the principal mortgage amount. For instance, if a borrower secures a $400,000 mortgage, one discount point would cost $4,000.

Lenders may offer the option to purchase full or fractional discount points, providing flexibility based on a borrower’s financial capacity. A half-point on a $400,000 mortgage, for example, would typically cost $2,000. These costs are generally paid at closing, adding to the total cash required to finalize the home purchase. While some lenders might allow the cost of points to be rolled into the loan balance, this practice increases the overall loan amount and could diminish the financial benefit. The specific cost and available fractional points can vary depending on the lender and current market conditions.

Impact on Your Interest Rate and Monthly Payments

Paying discount points directly impacts the interest rate applied to your mortgage, leading to lower monthly payments. Typically, each discount point purchased can reduce the interest rate by approximately 0.125% to 0.25%. For instance, if a mortgage rate is initially 5% without points, one discount point might lower it to 4.75%. Purchasing two points could further reduce the rate to 4.5%. The exact reduction per point can vary by lender, loan type, and prevailing market conditions.

A lower interest rate translates into significant savings over the life of the loan. For example, on a $400,000 mortgage, an interest rate of 6.5% might result in a monthly payment of approximately $2,528. If two discount points were purchased, costing $8,000, and the rate dropped to 6%, the monthly payment could decrease to about $2,398, representing a monthly saving of $130. Over the full term of a 30-year mortgage, these monthly savings accumulate, reducing the total amount of interest paid. Discount points are considered prepaid interest and may be tax-deductible.

Determining if Buying Down is Right for You

Deciding whether to buy down your interest rate involves evaluating your financial situation and long-term plans. A key calculation to consider is the “break-even point,” which is the amount of time it takes for the monthly savings from a lower interest rate to offset the upfront cost of the points. To determine this, divide the total cost of the discount points by the monthly payment savings achieved. For example, if points cost $3,000 and save $50 per month, the break-even point would be 60 months, or five years.

If you anticipate keeping the mortgage for a period longer than the break-even point, purchasing points could lead to overall financial savings. If you plan to sell the home or refinance the mortgage before reaching the break-even point, the upfront cost of the points may not be recouped, resulting in a net financial loss. Other factors include the opportunity cost of using funds for points versus other investments or expenses, such as a larger down payment. While permanent rate buydowns are common, some lenders or builders may offer temporary buydowns, which lower the rate only for an initial period.