When should you buy down your interest rate?
Most people who are shopping for a mortgae cringe at the thought of paying points. Few realize that there are points out there that can save you thousands of dollars over the life of your loan.
The Three Types of Points
In explaining points, it is important to note that there are three kinds of points that can be charged on a loan. First, you have what I like to call Operational Points. These are points that can be charged in order to pay the person who is working on your mortgage for their time (Example: Origination Points). The second type of points are Risk Based points. These are charges the lender can add to your costs based on how risky of an investment your loan is (Examples include low equity, bad credit, investment property, stating income, etc.) The third type of points are commonly known as Investment Points. It is important for potential borrowers to understand that these points can actually save you money over the life of your loan, thus commonly referred to as "good points" since they actually benefit the borrower.
Leveraging Your Equity
When buying down an interest rate, what you end up doing is using the equity that is locked up in your home to lower your interest rate as well as your monthly payment. Since the rate of return of equity is essentially 0% (see Gregory Wilder's article entitled "Should you leverage your home?" for a much more detailed explanation of this) we can utilize some of this stored up cash to invest in a cheaper interest rate from the lender. Typically you can obtain about a 1% cheaper interest rate in a 30 year fixed mortgage by paying the lender roughly 4 points, or raising the loan about by about 4%, thus investing some of your equity.
Reaping The Rewards
Even though we lost some equity in the above transaction, it is important to look at the average rate of appreciation for real estate in your area. Even with the drop in property values that we have seen recently, there are still many markets in the US that are on the rise. In most cases, the rate of appreciation for your home will offset the equity investment you make to get a lower rate in less than a year.
EXAMPLE: A homeowner refinances a $300,000 mortgage on her home in Albuquerque, New Mexico that is valued at $400,000 (equity = $100,000). She pays 4 points to get her rate down. Her new loan amount would be $300,000 (closing costs, say $2,000) (4 points, AKA 4% * $300,000) = $314,000. In this example, the homeowner invested $12,000 of her equity in order to buy down the rate. The 2006 average appreciation rate for residential property in Albuquerque was 13.6%. Assuming this trend continues for the next 12 months, her home would be worth $452,000, making the equity after one year $138,000 -- a net increase of $38,000!
The borrower also reaps a substantial savings over the life of the loan in the amount of interest paid. In the example above, a change in interest from 7% to 6% on a 30-year fixed would save her $57,589.
Calculating The Break-Even
Determining whether buying down an interest rate makes sense depends on how long you plan on being in your home and in the same mortgage. Buying down a rate makes less sense if you either a) plan on moving out of your home in the near future, or b) expect interest rates to fall and plan on re-financing. Although the latter is a bit harder to predict, the first can be calculated fairly easily. Simply take the added cost of buying down the rate and divide it by the incremental benefit. In the case above let's say our monthly payment was lowered by $200 by getting into a lower interest rate. We could simply divide 12,000 by 200 and come up with 60. This means it would take 60 months or 5 years of incremental savings to offset the extra equity investment, not taking property value appreciation into account.
Should you buy down your rate? This question should be a little easier to answer now that you understand the costs and benefits involved. Figure out your own situation and you could save thousands in the long run.
- Last edited June 13 2007
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