How Mortgage Points Work
Buying A Lower Interest Rate With Points
The purchase of a home is often the biggest investment someone makes in their life. With this being such a large financial decision, home buyers must know all the tools at their disposal that can impact their monthly expenses. It’s for that reason that it’s so surprising that many borrowers aren’t aware of the ways they can lower their interest rate with mortgage points! Let’s solve that problem by breaking down what points and buydowns are, how they work, and the ways a homebuyer can benefit from using them.
The interest rate on a mortgage is one of the main drivers impacting the monthly payment a borrower will carry over the term of the loan. Often referred to as the “cost of borrowing money”, the interest rate determines how much a borrower will pay in addition to the repayment of the principal of the loan. The rate will change with the market and can be influenced by several factors.
Some can be seen in many different areas aside from mortgages, such as inflation, Federal Reserve policy, and the general strength of the US economy. Other factors are more lending-specific, like the state of the housing market as well as the bond market.
The rate will continue to increase and decrease as those factors change, but borrowers are able to lock in their rate as soon as they have a signed purchase agreement (for purchases) to avoid any further movement in the rate. While most of what impacts the interest rate can be out of a borrower’s hands, it’s at the point of locking the rate that borrowers can use points and buydowns to help lower their rate and monthly payment.
What Are Mortgage Points And How Are Points Calculated?
“Buying points” is the process of paying a one-time fee charged by the mortgage lender in exchange for a lower interest rate on a loan. 1 point equals a fee of one percent of the loan amount, so if you pay one point on a $500k loan amount, you are paying $5k in points. In most cases, one point will yield a reduction to the rate ~0.25%, however this varies depending on the loan amount and product. This reduction is permanent and applies to the entire 30-year life of the loan. These points also don’t need to be whole percentages and can be smaller if the rate allows (i.e., buying half a point for a 0.125% reduction to the rate).
Assuming the same loan amount as above, paying one point to reduce the interest rate from 6% to 5.75% would translate to a monthly savings of almost $80. Over the course of 30 years, that one $5k investment will save a borrower over $28,000. Talk about a return on investment!
When you are consulting your lender about whether or not to pay points, make sure you specify what the points are going to and what benefit they offer you. Often times lenders will use the term “points” interchangeably between both discount points (explained above) and origination points. Origination points are charged by a lender and do not reduce the interest rate on the loan. Always review your estimated closing costs to see if you are being charged discount or origination points.
Drawbacks To Buying Down Your Interest Rate
So, what’s the catch?
While buying down your rate with points is a great way to lower your monthly payment, it is not the right option for everyone. Aside from the fact that they can be pricey, when a borrower pays points, they are playing the long game with the return on investment. The $28k savings reference above is enticing, but it took 30 years to generate. A borrower will need to keep the loan long enough to recoup their initial investment, which isn’t always easy.
Using the above example, with a savings of $80 per month, it would take a borrower ~62 months (over five years) before they made their money back. In that five-year period, if the borrower was to refinance their existing loan when rates come down, sell their home, or pay off the mortgage entirely, they’d be leaving money on the table. It’s for this reason that it’s vital that borrowers consider all options available before deciding to pay points to lower the rate permanently. In scenarios where borrowers know they will not carry that loan long (planning to move, rates are supposed to drop, etc.) there is a great second option to pursue!
What Is A Temporary Mortgage Rate Buydown
Exactly as they sound, temporary buydowns are available to buyers looking to lower their interest rate significantly for a shorter period of time. Rather than a permanent rate reduction using points, a temporary buydown is a seller-paid program that can lower an interest rate by one, two, or even three percent.
At closing, the seller will extend a credit that the buyer can use to qualify for this program. Using the same scenario above on a $500k purchase price, the credit would be $21,768 and allows the buyer to take their 6% rate down to 3% for the first year, 4% for the second, 5% for the third year, before finally increasing back to the locked-in rate of 6%. These savings to the monthly payment are frontloaded and a perfect option for those clients who know they won’t be keeping their mortgage much longer than a few years.
In the one-off scenario that rates drop and open an opportunity to refinance, temporary buydowns do not leave any money on the table! If the borrower refinances after the first year, the money leftover from the initial $21k seller credit will automatically be applied to the principal balance of the loan.
Just like with paying mortgage points, however, temporary buydowns aren’t always right for buyers! The main hurdle for this program is the fact that it is explicitly seller-paid. Depending on the competitive nature of the market, certain sellers may not be inclined to offer a credit.
JVM lending can help you decide whether or not you should purchase mortgage points to lower your interest rate and thus reduce your monthly mortgage payment. Our team of experts can guide you through the mortgage process and ensure you can comfortably afford your new home.