Some existing and prospective homeowners out there are fixated on obtaining the lowest possible mortgage 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 slightly higher mortgage rate to avoid paying closing costs when buying a home or refinancing a mortgage, some homeowners will pay the one-time fees in exchange for 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 decent chunk of time, as associated savings aren’t usually realized for several years into the loan.
How Buying Down Your Mortgage Rate Works
- When you apply for a home loan you’ll be given the opportunity to buy down your rate
- This requires paying mortgage discount points out-of-pocket at closing
- These points are a form of prepaid interest that reduce your interest rate
- It’s totally optional and ultimately boils down to whether you want an even lower 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 a common practice in the mortgage industry.
In short, if you pay mortgage discount points at closing, aside from any commissions and any other lender fees, you can bring your interest rate down to a lower level. And then save money each month via a lower mortgage payment.
For example, if the bank or broker says you qualify for a 30-year fixed at 4.25% with no points, but you want a rate of say 3.875%, you can ask them what it would take to get the desired rate.
They may come back and tell you that it will cost one mortgage point to buy down the rate, at which point you’ll need to decide if the monthly savings support the upfront cost.
If that mortgage point sets you back $2,000 at closing, you need to know how long it will take to recoup the cost, and if you will still have your mortgage at that time.
Should You Buy Down Your Rate?
- This is a very important question you should know the answer to early on in the loan process
- Think about how long you plan to keep the mortgage and the property
- And what the cost is to lower your rate to a certain level
- Then determine the break-even period which is the amount of time it will take to recoup the upfront cost
You may have seen mortgage advertisements for “no point mortgages” or “zero point mortgages,” and might 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 loans, buying down the interest rate may be a better idea.
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.
For example, if your interest rate at the par rate is 6.25%, but you’d like a rate of 6%, you’ll need to buy down that rate by paying a specified amount (or fraction thereof) of mortgage discount points.
As noted, mortgage discount points are a form of prepaid interest that can lower your mortgage rate if you so desire.
You’re essentially paying the interest upfront as opposed to monthly via higher principal and interest payments.
A mortgage 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 interest rate listed above 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. This means no points are paid, but there could still be other closing costs.
And the rate of 6.375% actually results in a lender credit, which is the opposite of a buy down because you get money back to cover closing costs.
But if you want a rate of 5.875%, you’d need to pay one mortgage point. If your loan amount were $300,000, we’re talking $3,000.
How Much Does 1 Point Lower Your Interest Rate?
- There isn’t a universal point-to-rate ratio that exists
- It can vary from bank to lender and also by the type of loan
- So you really need to find the sweet spot by getting multiple quotes from each lender you work with
- Find out where the rate buydown is best justified by the cost
If you look at the buy-down ratio for each rate listed above, it isn’t exactly a perfect science. Well, at least not to us non-bankers.
Usually as the interest rate moves 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 of a percent to 5.75%. That probably wouldn’t make much sense.
The same is true when moving below key levels like from 6% to 5.875%. Lenders probably know you want that lower rate because it just looks and feels so much lower.
So watch out for a big bump in price at these psychological levels.
Decide What Works Best Based on Math
- Don’t chase a certain interest rate arbitrarily
- Like 2.99% or some other emotional number
- Run the numbers and do the math with an actual calculator
- That way you can see what exact buydown (if any) makes the most 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 an exact 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 this comparison of mortgage payments on a $300,000 loan amount
– Interest rate of 6.25% with a price of 0.00 Monthly payment: $1,847.15
– Interest rate of 5.875% with a price of 1.00 Monthly payment: $1,774.61
Total monthly savings: $72.54
Total cost to buy down rate to 5.875%: $3,000.00
It would take roughly 33 months to realize the savings associated with the lower rate of 5.875%, factoring in potential tax deductions and savings accounts yields.
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.
Simply put, if you sell/refinance before month 33, you essentially lose money when paying for a lower rate upfront.
But after month 33, the savings of the lower rate begin to accrue…
Keep It to Yourself to Snag an Even Better Deal
- Don’t talk about paying points when you first start shopping for your home loan
- This can help ensure you receive the best offers upfront
- Only once you’ve really negotiated should you ask about buydowns
- Then you can attempt to move your best quote even lower
One last tip before you go and shop rates. If you are interested in paying points, it might be in your best interest (literally) to keep that to yourself, at least initially.
If you tell the loan officer or mortgage broker that you’re willing to pay points, they may think it’s okay to offer a slightly higher rate and simply highlight the post-buydown rate.
Instead, search and negotiate for the lowest rate possible, then once you’ve exhausted yourself and the salesperson, ask what it’ll cost to go lower. This may be the most effective way to truly see how low you can go.
In summary, 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. Or if you quickly refinance.
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.