What Does It Cost to Buy Down an Interest Rate?
Understand the financial strategy of buying down an interest rate. Explore the costs, benefits, and key factors to consider for your loan.
Buying down an interest rate is a strategy where a borrower pays an upfront fee to secure a lower interest rate on a loan, most commonly a mortgage. This approach aims to reduce the overall cost of borrowing money over the loan’s duration. While it requires an initial payment, the intention is to achieve long-term savings through reduced monthly payments. Understanding its mechanics and financial implications is important for borrowers considering this option.
Understanding Interest Rate Buy-Downs
Buying down an interest rate involves “mortgage points” or “discount points.” These points are prepaid interest paid directly to the lender at closing. One mortgage point is equivalent to one percent of the total loan amount. For example, on a $250,000 mortgage, one point would cost $2,500.
By purchasing these points, a borrower can reduce the interest rate applied to their loan for the entire term. The exact rate decrease per point varies among lenders and is influenced by market conditions. One point typically lowers the interest rate by 0.125% to 0.25%. More points generally result in a greater interest rate reduction, leading to lower monthly payments. Lenders may offer whole points, half points, or even fractions of a point.
Calculating the Upfront Cost
The upfront cost to buy down an interest rate is calculated based on the loan amount and the number of points purchased. Since each point equals one percent of the total loan principal, the cost is directly proportional to the loan size. This upfront payment is typically added to the closing costs and is due when finalizing the loan agreement.
For instance, if a borrower secures a $400,000 mortgage and decides to purchase one discount point, the cost would be $4,000 (1% of $400,000). If the borrower opts for two points, the upfront cost would double to $8,000. Similarly, purchasing half a point on the same $400,000 loan would cost $2,000. This calculation is a fundamental step in evaluating the financial feasibility of buying down an interest rate.
Determining the Financial Benefit
Assessing the financial advantage of buying down an interest rate involves calculating both the monthly savings and the “break-even point.” The monthly savings are determined by comparing the payment on the original interest rate with the payment on the reduced interest rate. For example, a $300,000, 30-year fixed-rate mortgage at 7% might have a monthly principal and interest payment of approximately $1,996. If buying down the rate to 6.75% reduces the payment to around $1,946, the monthly savings would be $50.
The break-even point indicates how long it takes for the accumulated monthly savings to equal the initial upfront cost paid for the points. It is calculated by dividing the upfront cost by monthly savings. Using the previous example, if the two points cost $6,000 and the monthly savings are $50, the break-even point would be 120 months, or 10 years ($6,000 / $50 = 120). Beyond this point, the borrower realizes net savings.
Total interest saved over the loan’s life can be substantial, especially for long-term mortgages. For instance, a small rate reduction can translate into tens of thousands of dollars in saved interest over three decades. Discount points paid on a primary residence mortgage may be tax-deductible in the year paid, if IRS criteria are met and deductions are itemized. For refinanced mortgages or loans on a second home, points are typically deducted ratably over the life of the loan. This potential tax benefit can enhance the financial return.
Factors to Consider Before Buying Down
Before deciding to buy down an interest rate, a borrower should carefully evaluate several personal and financial factors. The anticipated loan term plays a significant role, as the financial benefit of paying points is realized over time. If a borrower plans to sell the home or refinance the mortgage before reaching the break-even point, they may not fully recoup the upfront investment. Understanding one’s long-term housing plans is essential.
The availability of upfront cash is another important consideration. Paying for points requires a lump sum payment at closing, which can be a substantial amount. Borrowers should assess if using this cash for points is the most beneficial allocation of funds. Alternative uses for available cash might include building an emergency fund, paying down higher-interest debts, or investing for other financial goals.
Current interest rate environments also influence the decision. In periods of high interest rates, a small reduction from points can lead to more significant monthly savings. Conversely, if rates are very low, the impact of points might be less pronounced. Ultimately, the decision should align with personal financial goals and a clear understanding of how long the borrower intends to keep the loan.