When it comes to buying a house, the importance of the interest rate on your mortgage cannot be overstated. When you’re dealing with loan amounts that are typically in the six-figure range, even a small difference in your interest rate can have a big impact on your bottom line.
Considering the large sums of money associated with buying a house and how large a monthly mortgage payment is in relation to household finances, it’s understandable that most home shoppers get number fatigue when shopping for home loans. But if you’re in the market for a mortgage, you should consider whether or not a mortgage rate buydown might make sense for you.
What Is a Buydown?
A mortgage rate buydown is when a borrower pays an additional charge in exchange for a lower interest rate on their mortgage. Just like lenders can help cover the borrower’s closing costs by charging a slightly higher interest rate, the door swings both ways. Borrowers can essentially buy a lower interest rate upfront.
Typically mortgage companies offer a 0.25% rate reduction in exchange for a point, or 1% of the home’s purchase price. So on a $200,000 home loan, paying an extra $2,000 could reduce your mortgage rate from 4.25% to a 4.00%.
Why Buy Down Your Interest Rate?
A lower interest rate can not only save you money on your monthly mortgage payment, but it will reduce the amount of interest you will pay on your loan over time.
Check out the difference in monthly payments and total interest paid on this $200,000 home loan example. You can also run the numbers on your situation using the Quicken Loans Mortgage Amortization Calculator.
- $200,000 loan at 4.25%
- Monthly payment (not including taxes and insurance) = $983.88
- Total interest paid = $154,196.73
- $200,000.00 Loan at 4.00%
- Monthly payment (not including taxes and insurance) = $954.83
- Total interest paid = $143,738.99
You may be thinking that an extra $30 a month might not be worth it. But over the 30-year life of that loan, you’ll save over $10,457 in interest!
Paying $2,000 at the start of the loan saved you over $10,000. If you stuck that $2,000 in a savings account with today’s average APR of 0.45%, you’d only make about $288 in interest in that same period.
Are There Drawbacks to Buying Down Your Interest Rate?
The question of whether or not to buy down your interest rate is a question of short-term vs. long-term planning. With down payments, closing costs and all of the additional expenses associated with buying a new home, a lot of home buyers are tapped out right at the start. Coming up with extra funds, especially when they’re not required, might not be appealing.
Also, just like any long-term money-saving strategy, it works the best if you plan to be in your home for a while. The math doesn’t quite work out in your favor if you are thinking about selling your home well before the 30-year term of the loan is up.
Figure out the break-even point by dividing the monthly savings by the cost of the reduced rate. In our example, you save around $30 a month by paying $2,000. That means it would take you 67 payments to break even, or around five and a half years.
Another consideration is PMI, or private mortgage insurance. If you have less than 20% equity in your home, you are paying PMI to cover the lender in the event that you default on the property. PMI can be expensive, most of the time more expensive than the savings you would get from a reduced interest rate. Talk to your mortgage banker to see if it might make more sense to put down a larger down payment in lieu of buying a lower rate.
Buying a lower rate is not for everyone. It takes additional funds at the start of your mortgage, and sometimes these additional funds can be hard to come by. But if you’re buying a home with a fixed-rate loan and plan to be there for a while, a little cash can go a long way to help you save.