August 27, 2021
Whether mortgage rates are - at all-time lows or rising, you might wonder if you should buy down your mortgage interest rate. Buying down your rate means you’ll pay a one-time upfront fee for a lower interest. Today, we’ll discuss how to know if it’s a smart choice or not. Read on to find out more, so you can feel confident in your decision.
Mortgage Interest Rates – The Basics
Before we dive into buying down your mortgage rate, let’s talk about how lenders see and quote interest rates.
First of all, most interest rates change daily – sometimes more than once. While other rates, like VA’s, are more consistent and might not change as often. Your lender will have their current interest rates. Each rate will either offer a credit to the borrower, cost nothing, or cost the borrower a one-time fee. Let’s break this down further.
- Credit – A higher rate will give the borrower a credit they can use towards closing costs.
- No credit or cost – An interest rate at par is a baseline rate - there’s no cost or credit. This is the rate many lenders quote when asked what their rate is for the day.
- Cost – A lower than par rate will cost the borrower a one-time fee.
The above rate structure applies to credit unions, banks, mortgage bankers that lend out their own funds, or mortgage brokers that broker out their loans to a third party. As a borrower, you’ll have a choice on whether you want a credit, take the par rate, or pay down your rate.
For example, if you’re short on closing costs, you could get a higher rate and receive a credit to help pay for those costs. If you’re happy with the par rate, you don’t have to do anything. But, if you want the lowest rate possible, you can buy it down. We’ll go more into that below.
What are the points on a loan?
Mortgage discount points are also called “buy down points.” A discount point is a one-time fee you pay for a slightly lower interest rate.
Let’s define the term point. A point is 1% of the loan amount. So, if you had a $200,000 loan, one point would cost $2,000.
Generally, 1 point buys a rate down from 1/8% (0.125%) to 1/4% (0.25%).
Here’s an example, but keep in mind, these rates could differ depending on when you’re reading this article, but the basic concepts still apply.
You’re getting a $200,000 home loan and are considering buying the rate down. Here are two options:
- 3% par rate has no extra cost
- 2.75% interest rate costs 1 point
1 point for a $200,000 loan is $2,000
Note - discount points are different from “origination” or “lender” points. These are points the lender charges for doing your loan. Many lenders, including PenFed, do not charge origination points.
How do mortgage points work?
Now let’s see how buying your rate down with discount points affects your payment. We’ll compare to see what the principal and interest rate would be for the two rates above
The difference between these two interest rates is $27 a month. Let’s do some math.
- $2,000 (1 discount point)
- Divided by $27 (monthly savings)
- Divided by 12 (one year)
- Equals 6.17 (round down to 6)
So, it would take six years to make up the cost of the $2,000. If you know, you’ll live in the home for ten years. It could be worth the $2,000. But if you plan on moving in 3 years – don’t do it.
Is it wise to buy down your mortgage rate?
The only way you’re going to know if it’s smart to buy the rate down is to run the numbers – as we did above.
Here’s an example of when buying the rate down doesn’t make sense:
Sometimes a borrower gets fixated on a rate and is willing to pay thousands of dollars in points to get it.
It could be that their friends just got a mortgage, and they want their rate to be as low or lower than their friends’. In that situation, it could make zero sense to pay thousands of dollars that will take years and years to break even on.
Cost to Buy Down Mortgage Rate
One important thing to know is that one discount point does not mean your interest rate will be reduced by 1%. Generally, 1 point will buy your rate down 1/8% (0.125%) to 1/4% (0.25%).
The cost depends on your credit score, the type of loan, and what the market is doing.
Just as rates change every day – so does how much one discount point lowers your interest. So don’t be surprised if the quote you get today is different from the one you get tomorrow.
The mortgage market is fluid. If you’re ready to move forward in your loan, lock your loan, and are satisfied with the rate and buydown, consider locking that day.
So, when comparing lenders, compare rates, fees, and the cost to buy your loan down. Once you have that data, select your lender based on excellent rates and service.
Rate Buy Down – Final Comments
Having the lowest interest rate possible sounds appealing. And for some getting a low rate (no matter the cost) is a status symbol – similar to having a high credit score. But, spending your hard-earned money on discount points isn’t always the best decision.
When asked about buying down the rate, Dave Ramsey suggested not doing it if you can’t make your money back in four years.
If this is your forever home, you can save $100 a month or more and recoup the cost in four years - it’s probably a good idea. But often, the numbers don’t work out that way.
And, keep in mind, although you may be planning to live in the home forever, statistically, the longest people are living in a home is ten years. Whereas first-time homebuyers generally only stay in their homes for three to five years. So don’t fall into the trap of buying down a loan that will take eight years to break even on, and you move in three.
The best thing about deciding whether to buy your rate down or not is that it just comes down to finances. You’ll be fine if you just ignore the emotion and status symbol of having the absolute lowest rate and crunch the numbers.
We hope we’ve helped you understand more about buying down your mortgage rate so you can decide what your best option is.
To learn more about PenFed loans or what loan is right for you: