Loan-discount, or “buy-down,” points are a one-time cost you may choose to pay your lender to reduce your interest rate. These points are usually optional. A point is equal to 1% of the size of the loan. So on a $100,000 mortgage, if you decide to pay a point up front, it will cost you $1,000 at closing. Let’s say you’re going to buy a house for your family. You intend to live there at least till the kids finish school, say 10 years from now. Interest rates are low so you’d like to lock one in now.
First, you get mortgage quotes from three lenders. To compare apples with apples, you ask each of the lenders for the best loan for which you qualify under the following terms: a 30-year fixed mortgage with no buy-down points. Let’s say two of the lenders offer you an interest rate of 7% with no points and the third offers you 6.5% with no points. Next, you compare the fees each lender is going to charge you. To do that, you ask them to fax you a “good faith estimate” of total loan and closing costs.
Here, you’ll find each lender’s fees itemized — along with estimates for closing costs that they have no control over, such as county taxes and fees. Lender fees, and the names of those fees, differ from lender to lender. They can include application fees, funding and review fees, and others. Some of these are occasionally waived in special loan promotions — and, in any case, they are often negotiable. Let’s say you discover that the fees of the three lenders are all roughly equal — give or take a hundred dollars.
In that case, you’d simply go with the lender with the lowest interest rate. But once you begin to work with a lender, he may offer you different options on that loan — particularly regarding buy-down points. He may, for instance, tell you that instead of getting a 6.5% rate, you can get a 6.25% interest rate if you simply pay a half-point up front. If we use the example of our $100,000 loan, that means you would pay $500 to bring the interest rate down a quarter of a percent. The lender may give you another choice — perhaps telling you that you can get a 6% rate if you pay a full point up front.
In that case, it would cost you $1,000 to knock half a percentage point off the loan. So how do you know when it pays to pay the point? It’s easier to figure than you might guess. To make it simple, let’s compare only two options: a 6.5% interest rate with no buy-down points vs. a 6% interest rate after paying one point ($1,000 in this case).
First, ask your lender what the principal and interest payments (P&I) will be under the two interest rates he’s quoting you. You’re comparing only P&I — not insurance and taxes, because the lender has no control over them. Though these costs may be added to your monthly mortgage bill so the lender can automatically pay them, they’re going to be whatever they’ll be regardless of the lender you choose. Your lender comes back and tells you that at 6.5%, your monthly P&I is $633. At 6%, it’s $600. A $33 difference.
To calculate how soon the extra point may save you money, take the cost of that point and divide it by your monthly savings. That will give you the number of months it will take to recoup the extra money you paid to buy down the interest rate. That’s called your “payback period.” In this case, $1,000 divided by $33 gives you 30. This means that after about 2 1/2 years, you will have recouped the $1,000.
After that, the savings are all yours. Extend these savings over the remaining life of the 30-year loan (330 months), and it ends up saving you $10,890! The exact payback period will differ depending on market rates and the lender you’re working with. Generally, however, you can expect it to be about 2 1/2 to 3 years. This means that if you’re buying a property to “flip” (sell quickly for fast profits), you don’t want to buy down the interest rate.
If you’re pretty sure you’re going to refinance in the next year or two, you’ll once again be better off not paying points. Another reason you might skip the points is if you’re cash-tight and need every dollar you have just to make the deal happen — even if you’re buying the property for the long term. If, on the other hand, you have the money to buy down the interest rate and you plan to own the property (be it your own home or a rental property) for a long time, buying down the interest rate can turn out to be a very good deal.
(Editor’s note: Justin Ford is editor of Main Street Millionaire. For more information on successful real estate investing click here: http://www.agora-inc.com/reports/XRE/WXRED401)