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Should I buy down my mortgage rate? Question
Some lenders offer an option where one can pay additional money in closing costs to get a lower APR. This is often called a rate or point "buy down". Is this a good idea?
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If you assume the value of money will not significantly change over the course of the loan, it is normally better to buy down rates as much as possible. This is similar to how a larger down payment is better - borrowing and repaying later is more expensive in the end than just paying now, because you have to pay additional interest.
Sometimes mortgages are priced such that for every dollar you put towards the point buy down, you get more value than if you had instead put it towards the down payment. So it can be advantageous to buy down as much as you can, even if you have to reduce the down payment. To be fair, the ideal target interest rate is not always 0% (more on that in a second) but usually there are regulations that will prevent you from even getting to the ideal buy down amount let alone go past it.
An interesting subtlety of buying down points is that they introduce a soft minimum duration to the loan. When buying down, you pay the cost in advance, and in the event of early repayment you don't get the money back. So if for example you take out a 10 year loan, pay a lot of money to buy down from 6% to 5%, and then close out the loan in your second year by paying early, you will have only paid say 1.5 years of interest. Because that's a short term, you may discover that the difference in 6% and 5% interest over such a short term is less than what it costs you to buy down the rate, so it is a losing decision. But if you hold the loan longer, for the entire 10 years, then the difference between 5% and 6% will be substantial and more than what you spent on the buy down.
For this reason, the points buy down is a way to gain money by successfully predicting whether you will pay off the loan early, and when that will happen (note that usually, when you sell a house you must close out the mortgage as well, since you are normally not allowed to owe money on someone else's house). For this reason, lenders will sometimes mention a "break even period" of some number of months. If you end up closing the loan before the break even time has passed, you would be losing money on the buy down. If you close it after, you will not.
Ultimately the decision depends on exact loan amounts, interest rates and closing costs. The way to settle this is to calculate amortization charts for:
- No buy down,
Xdown payment and the base rate - Buy down with
Ycost,X-Ydown payment and the lower rate
You can the compare the total interest and decide for yourself whether the savings are worth it. It's important to look at the amortization chart, because you can also do "what-if" analysis and see the consequences of paying off the mortgage early.
Lastly, another factor is that money changes value over time - normally losing it due to inflation. It's important to keep this in mind when looking at future interest savings vs. extra closing costs today. Ideally, you would make your calculation in real terms (adjusted for future inflation) but it is difficult to predict inflation many years into the future. You will have to go by nominal figures, and just keep in mind that future money is not equivalent to present-time money.
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Do the math!
Calculate the present value of each loan. Add the buy down amount to the cost of the loan with the lower interest rate. Whichever is lower wins.
That said, there are some additional considerations beyond the simple question you asked:
- Can you afford the larger up-front payment? If you don't have the cash, then it's a moot point.
- Compare to using the initial payment to reduce the size of the loan in the first place. More money down may get you a better rate. Having the bank implicitly do this for you with a "buy down" quite possibly costs more.
- Consider whether you expect to pay off the loan early. The more the buy down payment, the longer the two loans need to run before the buy down version wins.
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