Interest Rate: Buying Down Your Mortgage Rate

This week a friend of mine was thinking about refinancing his house and asked what I thought about buying down the interest rate. I thought this was a great topic for this week’s newsletter, so here is the scoop.

You can get a lower interest rate for a price when obtaining a new home loan or refinancing an existing mortgage. The industry has a clever name for this…“buying down the rate.” The price you pay for the lower rate is called “points.”

Is the “no cost” refi really the best deal?

Many mortgage advertisements tout “no points or fees.” However, paying a one-time fee for a lower payment each month may be a better idea. Step one is to get your hands on the rate sheet, which looks something like this:

 

Interest Rate
Price
4.375% (0.375) negative number denotes a lender credit
4.25% 0.00
4.125% 0.50
4.00% 1.00
3.875% 1.75

 

Suppose you had your heart set on a 4.0% interest rate, but the going rate is 4.25%. You can still get that 4.0% rate, but it is going to cost you one point. This means you make a one-time payment equal to 1% of the loan amount.

Let’s look at an example:

Let’s say my friend’s mortgage was $400,000. His payment at 4.25% (principal and interest) on a 30-year fixed loan would be $1,968 per month. He could pay one point ($4,000) to reduce his rate to 4.0%, which would reduce his payment to $1,910. Therefore, he would be paying $4,000 one-time to save $58 per month for the life of the loan. This gives us a 69 month breakeven point $4,000/$58 (for simplicity we will ignore the interest we might have earned if we invested the $4,000 and also the tax deduction we would receive for paying the $4,000, which is treated as additional interest expense).

Interest Rate: Buying Down Your Mortgage Rate

This buy down is a great deal if he stays in his home for the term of the loan (360 months). He would have paid $4,000 upfront to reduce his total interest expense by $20,880 over the course of 30 years. The average tenure of home sellers last year was around 10 years and the average life of a mortgage is around 5 ½ years. People typically refinance when rates drop by .5% or more and/or if they like to use their house like an ATM.

The buy-down ratio for each interest rate isn’t linear:

The price goes higher, often disproportionately, as the interest rate goes lower. You can see in the rate sheet above that it only costs .5% to buy down the rate by .125% from 4.25 to 4.125, but it cost .75% to buy it down from 4.0% to 3.875%. That’s why it’s important to decide on a pricing threshold where it makes sense to buy it down.

Rolling the fees into the loan:

Let’s add one more wrinkle to this analysis. We can either pay the fees ($4,000 in our example) out of pocket, or we can roll them into the loan. Rolling the fees into the loan increases the loan amount from $400,000 to $404,000 but still decreases the payment from $1,968 to $1,929. This, to me, seems like a no-brainer. We were able to decrease our payment by $39 per month by buying down the rate, without any money out of pocket. This also reduces the total interest paid over the course of the 30 years by $18,041.

On the other hand, paying 1 point to buy down the rate by .25% (in our example) would have been almost a $2,000 mistake, if my friend sold his home or refinanced after only 3 years. The bottom line is the longer you stay in the house (without refinancing again), the more it makes sense to buy down the rate, and it usually makes sense to roll the points into the loan. Do you want to crunch some numbers related to your own mortgage situation? Check out this mortgage calculator.

If you are looking for other mortgage options, homeowners over the age of 62 might consider a reverse mortgage, which is the only way to borrow money against the equity in your home without ever having to make a payment.