How Much It Costs to Buy Down an Interest Rate

Buying down an interest rate on a mortgage means paying an upfront fee to the lender to secure a lower interest rate for the duration of the loan. The decision to buy down a rate can potentially reduce your monthly mortgage payments and the total interest paid over the loan’s life.

Understanding Mortgage Points

Mortgage points are prepaid interest paid upfront at closing to reduce a loan’s interest rate. One point typically equals one percent of the mortgage loan. For instance, on a $300,000 mortgage, one point would cost $3,000.

Discount points are paid to lower the interest rate over the loan’s life. In contrast, origination points are fees paid to the lender for processing and underwriting the loan; they do not reduce the interest rate.

Lenders offer discount points in various increments, such as 0.5 or 1.25 points. Each discount point purchased can lower the interest rate by approximately 0.125% to 0.25%. This reduction applies over the entire loan term for fixed-rate mortgages, leading to lower monthly payments.

Calculating the Cost and Savings

The cost of buying down an interest rate is calculated by multiplying the loan amount by the percentage of points. For example, on a $400,000 mortgage, one point (1%) would cost $4,000. If a lender offers 0.5 points, that would be $2,000 on the same loan, potentially reducing the rate by about 0.125%.

To calculate monthly payment savings, determine your principal and interest (P&I) payment with and without the points. For example, a $250,000 mortgage at 3.5% over 30 years might have a monthly P&I payment of about $1,123. If one point costing $2,500 reduces the rate to 3.25%, the monthly P&I payment could drop to about $1,088, representing a monthly saving of $35.

The breakeven point is the time it takes for monthly interest savings to equal the upfront cost of the points. To calculate this, divide the total cost of the points by the monthly savings. Using the previous example, if points cost $2,500 and save $35 per month, the breakeven point would be approximately 71.4 months ($2,500 / $35), or about 5 years and 11 months.

Discount points, as prepaid interest, may be tax-deductible. Under IRS Publication 936, you can generally deduct points over the life of the mortgage. You might deduct the full amount in the year paid if specific IRS tests are met, such as the loan being secured by your main home, the points being an established business practice, and the amount not exceeding generally charged points. If these tests are not met, or if the loan is for a second home or a refinance, the deduction must be spread out over the loan’s term.

Key Factors to Evaluate

The planned length of stay in the home is a key consideration. If you anticipate selling or refinancing before reaching your breakeven point, the upfront cost of points may not be recouped. For example, if your breakeven point is five years, but you plan to move in three years, you would incur a net loss from buying points.

The prevailing interest rate environment also influences buying down a rate. In a period of high interest rates, a small reduction can lead to substantial monthly savings. However, if market rates are expected to fall significantly, a future refinance could make the initial investment in points less beneficial.

Consider the opportunity cost of funds used for points. This money could be used for other financial goals, such as increasing your down payment, paying off high-interest debt, or investing. For instance, a larger down payment could reduce the loan amount and potentially eliminate private mortgage insurance (PMI). Evaluate alternative uses of capital to determine if buying points is the most efficient allocation of your funds.

The loan term affects the impact of buying down the rate. On longer terms, such as a 30-year mortgage, total interest paid is considerably higher. A small reduction in the interest rate can lead to more significant overall savings.

The Process of Buying Down

The decision to buy down an interest rate is typically made during the mortgage application process, often when locking in your interest rate. Lenders present different rate options, some including paying points for a lower rate.

Payment for mortgage points is usually made at closing, as part of your overall closing costs. These costs are itemized on official mortgage documents. The Loan Estimate, provided within three business days of applying, details estimated costs, including points. The Closing Disclosure, received at least three business days before closing, provides the final figures for all closing costs, including points.

Points are often listed as “prepaid interest” on these documents, distinguishing them from other fees like appraisal or title insurance. While rolling the cost of points into the mortgage loan is possible, it increases the principal balance and accrues interest. Paying points out of pocket at closing is generally advised to maximize financial benefit and shorten the breakeven period.