How Much to Buy Down a Mortgage Rate?
Evaluate if an upfront mortgage investment yields long-term savings. This guide helps you assess costs, benefits, and the ideal timing for your financial goals.
When securing a mortgage, borrowers often encounter the option of “buying down the rate,” a strategy involving an upfront cost to reduce the interest rate on their home loan. This payment, known as points, aims to lower the total interest paid and decrease monthly mortgage payments. Understanding the mechanics, financial impact, and influencing factors of these points is important for determining if it aligns with an individual’s financial goals.
Understanding Mortgage Points
Mortgage points, specifically termed “discount points,” are prepaid interest paid to the lender at closing. One discount point typically equals one percent of the total loan amount. For instance, on a $350,000 mortgage, one point would cost $3,500. These points are exchanged for a lower interest rate, which can lead to reduced monthly payments over the loan’s term.
The amount a discount point reduces the interest rate can vary, but a common range is between 0.125% and 0.25% per point. Lenders establish their own frameworks for how much rate reduction each point provides, influenced by market conditions and the type of loan. It is important to distinguish discount points from “origination points,” which are fees charged by the lender for processing and underwriting the loan and do not reduce the interest rate.
Calculating the Financial Impact
The decision to pay mortgage points requires a clear understanding of their financial implications, including the upfront cost, the reduction in monthly payments, and the long-term interest savings. To calculate the dollar cost of paying points, multiply the percentage of the point by the total loan amount. For example, on a $350,000 loan, if a borrower opts to pay two discount points, the upfront cost would be $7,000 ($350,000 x 0.02). This amount is paid at closing as part of the overall closing costs.
Paying points reduces the interest rate, which in turn lowers the monthly mortgage payment. Consider a 30-year, $350,000 mortgage at an original interest rate of 7.00%, resulting in a monthly principal and interest payment of $2,328.60. If two points reduce the rate to 6.50%, the new monthly payment would be $2,212.78. This change represents a monthly saving of $115.82.
The long-term benefit of paying points is the total interest saved over the life of the loan. In the previous example, a 30-year loan at 7.00% would accrue $488,296 in total interest. By reducing the rate to 6.50% with points, the total interest paid drops to $446,600.80, leading to total interest savings of $41,695.20 over the loan’s full term.
The “break-even point” indicates how long it will take for the monthly savings to recoup the initial cost of the points. This is determined by dividing the total cost of the points by the monthly payment savings. Using our example, with an upfront cost of $7,000 and monthly savings of $115.82, the break-even point is 60.44 months ($7,000 / $115.82). This calculation reveals the number of months the borrower must keep the mortgage to begin realizing net savings from paying points.
Key Considerations for Your Decision
After calculating the financial impact of paying mortgage points, several personal circumstances should influence the decision. These considerations help determine if the upfront investment aligns with an individual’s financial situation and long-term plans.
The length of time an individual plans to stay in their home is a factor. If the calculated break-even point is longer than the anticipated duration of homeownership, paying points may not be financially advantageous. Conversely, if the individual expects to remain in the home well beyond the break-even period, the long-term savings from a lower interest rate can be significant.
The availability of cash is another consideration. Paying points requires a lump sum payment at closing, which could otherwise be used for other purposes, such as increasing the down payment, establishing an emergency fund, or making other investments. If cash reserves are limited, retaining liquidity might be more beneficial, even if points offer long-term interest savings.
The loan’s term also influences the overall effect of paying points. Longer loan terms, such as a 30-year mortgage, accrue more total interest over time, making a rate reduction more impactful in terms of overall interest saved. The break-even period remains a primary driver, as it dictates when the initial investment in points is recovered.
Mortgage points paid to reduce the interest rate are tax-deductible. For loans used to purchase or build a primary residence, these points can be fully deducted in the year they are paid, provided certain Internal Revenue Service (IRS) criteria are met. For refinanced loans or loans not meeting specific criteria, points are deducted ratably over the life of the loan. The deduction is reported on Schedule A (Form 1040) if itemizing deductions. Consult a tax professional for guidance on the deductibility of mortgage points, especially given potential limitations on interest deductions for larger mortgage amounts.