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Does a mortgage rate buydown or paying points give you the best mortgage rate?

Posted by  on Dec 13, 2010
 

 

Dear Liz, I want to refinance and I want the lowest mortgage rate possible. I thought that was called "buying down" my mortgage rate. But I looked that up online and there is all this stuff about 2-1 mortgage buydowns! Are they the same thing? Ray, Michigan

Both terms mean getting a lower mortgage rate by paying extra, but the way these programs work is very very different.

"Buying down" your mortgage rate means paying points.

When you shop for a home loan and compare mortgage quotes, you usually get several rates from each lender. One might be for a loan with customary fees like an origination charge and title and appraisal fees. The same lender might quote you a rate with NO lender fees or third party charges. Of course, this rate is higher. Then, you might be quoted a discount rate, which is the best mortgage rate. However, the lower an interest rate is, the more it costs. These extra costs are called "discount points" because they are paid to get a discounted rate on your home loan. Paying these extra costs is known as "buying down" your mortgage rate.

Is the lowest mortgage rate always the best deal?

Only if your main objective is having bragging rights at cocktail parties. The best mortgage rate may be so costly that you'd never save enough money on your monthly payments to make it worthwhile. A mortgage calculator can help you decide. If you know that you will be keeping the mortgage for its entire term, use the Shoprate.com APR calculator, and choose the option with the lower annual percentage rate (APR). For example, if you refinance a $300,000 mortgage with $2,000 in fees and want to see if it's better to pay 4 points for a 3.75% mortgage rate or no points for a 4.25% rate, input these numbers into the calculator. You can see that the APR of the 3.75% loan is 4.13%. The APR of the 4.25% rate is 4.31%. So if you can afford the points and are absolutely sure that you'll be keeping the loan for its entire term, the 3.75% loan costs you less over time.

What if you only plan to keep your loan for, say, five years? Then calculate your savings differently, using the loan comparison calculator. Your monthly payment at 3.75% is $1,389 and it's $1,476 at 4.25%. The difference is $89, and over five years your savings is $5,340. The four points cost $12,000, and it makes little sense to spend $12,000 to save $5,340.

Ok, what's a 2-1 buydown?

The 2-1 buydown gets you a lower mortgage rate and payment for the first two years. So, if the 30-year rate is 4.125%, your interest rate for the first year would be the stated rate minus 2% (2.125%), and in the second year the rate would step up one percent (to 3.125%), and then in year three the rate would revert to 4.125%.

But here's the kicker. The cost of the buydown is equal to the savings afforded by the lower interest rate. You pay upfront for the buydown, pretty much like this:

For a $200,000 loan at 4%, the interest for the first year is approximately $8,000 (it's a much more complicated calculation but this does illustrate how buydowns work). So, if you pay only 2% the first year, or $4,000, that's a $4,000 difference. The second year, at 3%, you're looking at interest charges of about $6,000, or a $2,000 savings. So the cost of the buydown for both years is $4,000 plus $2,000, or $6,000. So you pay $6,000 upfront to save $6,000 over two years. It only makes sense if you can get a seller to pay this when you buy the home.

The bottom line

The fundamental difference is that when you pay points, you may save more than you spend, or you may spend more than you save--it depends on your time frame and the cost of the lower rate. But with buydowns, your cost equals your savings.

 



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