The first thing most of us look at when we go mortgage shopping is the interest rate. We all want the lowest one possible, right? Not necessarily. While it's almost always possible to "buy down" the interest rate, it isn't always a good idea. To make an informed decision, you need to figure out when you're better off not buying down the rate and sticking with a higher one.
The biggest reason people buy down the rate -- or make an additional up-front payment in return for a lower interest rate over the life of the loan -- is that a lower interest rate means lower monthly payments. There is another reason we'll discuss later: lower income taxes.
First, however, let's look at what's involved in "buying down" the rate and why lenders offer it as an option. Lenders make their money from the interest they collect month after month, year after year. The return on their loan investment is steady but slow. That's why they usually are willing to trade some slow but bigger, long-term profits for faster but smaller, short-term ones. That's what a mortgage buy down is: a faster profit for the lender in exchange for a lower, long-term interest rate for the borrower.
That fast profit is expressed in points, explains Doug Duncan, the chief economist for the Mortgage Bankers Association of America, the industry's trade association. In lending terms, a point is 1 percent of the total amount of a loan. Most lenders will reduce your interest rate by a fraction, usually a quarter of a percentage point, for each point you give them up front when you take out the loan.
So when you negotiate the loan you ask what the interest rate would be with zero points, or no up-front payment at all, says Duncan. "Then you ask what it would be with one point, two points, and so on. The amount you can lower it probably varies from lender to lender, but I would think that the most you could lower it would be two percentage points, if that much. Doing so would be quite expensive, however. Let's look at some examples.
The basic monthly payment on a 30-year loan for $100,000 at 5.5 percent interest, excluding taxes, insurance, assessments or fees, would be $567.79. That covers only interest and principal. If you could lower the rate by one-quarter of 1 percent, down to 5.25 percent, by paying one point or $1,000, your new payment would be $552.20. You would save $15.59 a month. That might not seem like a large savings until you look at it long term. If you kept the loan for the full 30 years at 5.5 percent, you would pay a total of $104,403.49 in interest. At 5.25 percent, the total interest would be $98,795.23, for a savings of $5,608.26 over 30 years.
But few people keep a mortgage for 30 years. The question then is: how long does it take to earn back the $1,000 you paid to buy down the interest rate? In this case, payback would come after five years and five months. After that, the $15.59 you save every month turns into pure profit on your one-point investment.
Let's see what happens when you drop the loan by a full percentage point, to 4.5 percent from 5.5 percent, by paying four points or $4,000, up front. (Remember, you're paying $1,000 for each quarter-percentage-point reduction in the rate.) Your monthly payment then drops to $506.69 from $567.79, for a monthly savings of $61.10. That's roughly four times the reduction you would get by paying for a one-quarter-point reduction. But it would still take five years and five months for you to actually save money on the deal. And if a lender let you buy it down to 3.5 percent for eight points or $8,000, your monthly payment would be $449.04, but it would take you 68 months to recoup your money.
We've seen what happens when you buy down the mortgage. Let's look at what you get if you use that money to reduce the loan instead. If you add the $1,000 to the down payment and borrow $99,000 instead, you would get a basic monthly payment of $562.11. That's a monthly savings of $5.68, but it's still $9.92 more in payment than if you had used that extra $1,000 to buy down the interest rate. Put $8,000 more toward the down payment and you get a monthly payment of $522.37, also more than if you had used the money to lower the interest rate by two points. So in terms of monthly payments, putting $1,000 or so toward lowering the interest rate makes more sense than putting it toward the down payment. But there is one other thing to consider when you are deciding whether to pay points -- income taxes.
You also have to look at it in terms of tax planning, Duncan says. You can deduct the points you pay to buy down the interest as a mortgage interest payment in the year in which you buy the house. So if you have a big bonus or sell some stock, the tax advantage of buying down a mortgage can offset at least some of the extra taxes you would have to pay on the extra money you made. Of course, he adds, by lowering the total interest you pay you also lower the amount of mortgage interest you can deduct from future taxes.
Tax laws are different, however, when you refinance.
The points you pay up front when you refinance have to be amortized over the expected life of the loan. If you refinance for 20 years and pay $4,000 in points, for example, that $4,000 deduction is spread out over 20 years, or $200 a year, in terms of tax deductibility. If you pay the loan off early, he adds, you can amortize the loan off early in the last year of payment. So after four years you have deducted $800, and then you pay off the entire loan in the fifth year. In year five you can deduct the remaining $3,200.
So does it make sense to buy down your mortgage interest rate? That depends on your individual circumstances. If you expect to keep the same mortgage for the next six, 10 or 20 years and you want the lowest monthly payment possible, then it does. But if you plan to move or refinance before you make back that money, it doesn't. You also need to figure your tax status into your decision. Ultimately, only you can determine whether getting the lowest rate now really is the best rate for you in the long run.