Many borrowers and prospective homeowners out there are looking for the lowest possible interest rate, even if it means pulling money out of their own pocket at the time of financing.
Though most borrowers usually opt for a higher mortgage rate to avoid paying closing costs when buying a home or refinancing, some savvy homeowners will pay the one-time fees and take a lower interest rate to save money over the long term.
Of course, this strategy only really makes sense if you plan to stay with the mortgage for a long period of time, as associated savings aren’t usually realized for several years.
Buying Down the Rate
If you’re working with a bank or mortgage broker, you can easily buy down your interest rate by asking for a series of different rates and associated costs. This is known as “buying down the rate,” and is common practice in the mortgage industry.
You may have seen mortgage advertisements for “no point mortgages” or “zero point mortgages,” and may be quick to jump on them. And though these no cost loans could serve you well to leverage your money, for borrowers who have decent asset reserves and plan to pay off their loan, buying down the interest rate may be a better idea.
Should you buy down your rate?
Deciding whether or not to buy down your interest rate can be tricky, but if you get your hands on a rate sheet, you can make the decision quite easily. Most mortgage programs have a system where you’ll pay a certain amount in “fee” for a specified change in interest rate.
Mortgage discount points are a form of prepaid interest that can lower your mortgage rate if you so desire.
A rate sheet may look something like this:
Interest Rate – Price
6.375% – (0.375)
6.25% – 0.00
6.125% – 0.25
6.00% – 0.50
5.875% – 1.00
5.75% – 1.75
Each rate has a corresponding price, which is simply displayed as a percentage of the loan amount. In the example above, the par rate would be 6.25%, as it has an associated price of zero.
How much does 1 point lower your interest rate?
If you look at the buy-down ratio for each rate, it isn’t exactly a perfect science. Well, at least not to us non-bankers. Usually as the interest rate goes lower, the price to buy down goes higher, often disproportionately. This actually makes sense because it gets increasingly expensive to go well below typical market rates.
As you can see, someone could pay one point for a rate of 5.875%, but be asked to pay nearly double that to get the rate down another eighth to 5.75%. That probably wouldn’t make much sense.
This is why it’s important to decide on a pricing threshold where it makes sense to buy it down instead of chasing a certain rate.
For some reason, homeowners seem to have a specific interest rate in mind that they must have. It’s foolish to go after a precise rate, especially when the cost associated may eclipse the actual savings you’d accrue over time with the slightly lower rate.
Even if you have your heart set on X rate, you may want to see what the lender is offering, then compare your mortgage payment at different rates and consider the associated costs for buying down to those rates.
Note: There may be a limit to how many mortgage points you can buy based on the new QM rules, along with how low the lender is willing to go. It also gets to a point where it no longer makes sense to keep going lower because the cost becomes excessive.
Look at a comparison of interest-only mortgage payments on a $500,000 loan amount
– Interest rate of 6.25% with a price of 0.00 Monthly payment: $2604.17
– Interest rate of 5.875% with a price of 1.00 Monthly payment: $2447.92
Total monthly savings: $156.25
Total cost to buy down rate to 5.875%: $5,000.00
It would take roughly 32 months to realize the savings associated with the lower rate of 5.875%. It may be worth it if you plan on staying in your home over a long period of time, but if not, it might be wise to stick with a slightly higher interest rate at no cost.
Do the math to figure out which rate makes the best sense to buy down based on your long term plan with the associated property. Buying down your interest rate can be a great decision, but also a foolish one if you pick up and go after a year or less.
And remember, don’t focus on an exact interest rate. It simply isn’t worth it sometimes, especially when the price doubles to drop the interest rate a mere eighth or quarter percentage point.
Read more: How to pay off the mortgage early.