Interest rates can drastically affect the cost of your mortgage. Buying down your mortgage rate is an effective way to save money on your monthly payments and reduce the amount of interest you pay over the life of the loan. In this guide, we’ll explain what it means to buy down a mortgage rate, how it works, and when it may be beneficial for you.
What does buying down the mortgage rate mean?
The process of buying down your mortgage rate involves paying an extra upfront fee to your lender at closing to secure a lower interest rate and monthly payment for the entire length of your mortgage. Otherwise known as, buying “mortgage points” or “discount points.”
Interest rates are determined by a variety of factors including the current market condition, and your credit score. Moreover, if you’re willing to make an initial lump sum payment, you may be able to buy a lower interest rate.
How does buying down your mortgage interest rate work?
During the home loan application process, you will be able to buy down your interest rate. It requires an out-of-pocket fee for mortgage discount points at closing. In essence, these points reduce your interest rate as they are prepaid interest.
Is it worth it to buy your rate down?
Buying down the interest rate on your mortgage loan could significantly lower your monthly payments, reduce the overall amount of interest you will pay over the life of the loan, and help reduce your debt-to-income ratio. Furthermore, it can help save you money in the long run and make your mortgage payments more manageable.
However, it’s important to ask and answer the following questions early in the process to decide if this will be beneficial to you!
- Consider how long you intend to keep the property and mortgage.
- What is the cost to lower the rate to a certain level?
- Determine the break-even period (the amount of time it will take to recoup the upfront cost.)
- Do you have extra cash reserves that could be paid at closing?
How much does it cost to buy down an interest rate 1 percentage point?
The cost to buy down an interest percentage point depends on the amount of your loan and the type of loan. Specifically, one mortgage point is equal to 1% percent of the total loan amount. For example, on a $500,000 mortgage, 1 point would cost you $5,000 at closing ($500,000 making the cost of your mortgage point $5,000).
How many points can you buy down the interest rate?
There is no set limit for how many mortgage points you can purchase, but most lenders limit borrowers to four points. Due to state and federal limitations, there are restrictions on the amount a borrower can pay in closing costs on a mortgage. Additionally, there may be a slight difference in the number of points you can purchase depending on the state you’re looking to buy in.
How much does 1 discount point lower your interest rate?
A discount point, not to be confused with buying down an interest rate percentage point, allows the borrower to reduce their monthly payments by purchasing a lower interest rate.
In terms of discount points, there is no fixed amount that will lower the rate. Depending on the lender, type of loan, and current mortgage rates, discount points have different effects.
If the buyer wants to reduce the rate 1 full interest rate point, it will likely cost them between 1 to 2+ points, depending on their credit score, loan-to-value, loan type, etc. In this case, you divide the cost of buying down the rate by the monthly savings amount.
Comparison of Mortgage Payments
The breakeven point is an important consideration when determining whether you should buy down your interest rate. Your breakeven point is the amount of time it will take to recoup the cost of the discount points required to lower your interest rate.
For example, to compare mortgage payments on a $300,000 loan at 7% vs 6%, find the difference in the principal and interest payment.
- $300,000 loan at 7% – P&I = $1996/month
- $300,000 loan at 6% – P&I = $1799/month
Difference of $197/ month
To calculate the breakeven point, divide the cost of points by the monthly savings once you have found the difference between the two mortgage payments. Based on this calculation, it will take you approximately 15 months to recoup your costs with an annual savings of $2,364.
If this seems like a big algebra class, leave it to our team of licensed mortgage professionals to crunch the numbers and to discuss the different loan scenarios that make sense for you!
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