Will you save money buying down your mortgage rate?

If you really want to save $ (flickr.com)

With the November 30th deadline for the $8000 tax credit rapidly approaching, buyers are out there scrambling, to buy that first home, and close by the deadline. I’ve heard a few home buyers discussing buying down the mortgage rate to keep the payments lower. But is this a good idea?

There is no short answer to this question, because it depends on many factors:

1. How much do you want to buy the rate down?
Did you know that buying your rate down 1/8% saves you only $5.71 a month per $100,000 of your loan amount?

2. What is the cost to you to buy the rate down?
• This figure has to be quoted to you on a daily basis, and depends on so many factors, it is difficult to imagine. Mortgage rates are based on the yield being paid on mortgage backed securities and 10 year bond yields.
• Lenders individually determine the amount of margin they want to make on the different types of loans, and this is based on the above factors, plus the cost of borrowing funds to lend, and the yield their investor will pay, if the loan is going to be sold. All these numbers are fit into a formula and the cost on any particular rate on any given day is determined.
• The actual cost is lender specific, because lenders have multiple sources to sell the loan to (such as Freddie Mac, Fannie Mae, private investors, other banks), and often pay different amounts to borrow money (based on their size, credit rating, etc.)
• To be sure, lenders do shop each other to make sure their rates are competitive, but they do each set their own costs to buy a rate down at any given time.
• Some lenders change their rates daily, while others change them frequently throughout the day as the markets change. There are a few lenders (primarily those that keep their loans, rather than sell them, that change rates as infrequently as once a week.) 

3. How much will you save monthly, annually, over the term of the loan?
It is important to know the cost of the buy-down. Banks don’t lower their rates to accommodate you. They are still looking for a profit, and buy-downs are usually expensive relative to your savings.

4.  Are you thinking about a permanent rate buy-down, or one of the more common short term buy-downs? These are usually referred to as 2/1 buy-down, or 3/2/1 buy-down. A 2/1 buy-down actually lowers your rate 2% the first year, 1% the second year, and settles at the “fixed note rate” thereafter.

5. Where is your break-even point?
• The “break-even” point is critical in determining whether or not a buy down is a good idea. For example, if you are getting a $100,000 loan with a 1/8% rate savings, you might pay as much as as ½ to 1 point for that buy down. So, you will pay $500 to $1,000 to save $5.71 a month. It will take you 87 to 175 months (7- 14 years) to break even.  Obviously this is an extreme example, but perhaps not as extreme as you might imagine.  A rate buy down from 5% to 4.875% this morning would cost you almost 1/2 point!  To buy down your rate 1/2% this morning would cost you almost 1.5 points!  You do the math.  Is this a good value for you?
• As a general rule, a 2/1 buy-down will cost 2 ½ points. For a $100,000 loan, this is $2,500. Your savings the first year will be $100 per month = $1200. Your savings the second year will be approximately $50.00 month = $600.00. The third year you will be paying the note rate. So your total savings will be $1800 at a cost of $2500. The bank will make a $700 profit on your buy-down. You will never break even.

It is a common misconception that a buy-down will allow you to qualify for a more expensive home. If it is a permanent buy-down (where your rate will never increase), this is perhaps the only time that a buy-down might make sense. However, with a 2/1 buy-down, for example, you will have to qualify for the loan based on the highest interest rate (the permanent note rate), so this will not afford you any advantage in terms of “buying power.”

In some cases, the cost of the buy-down can be added to the mortgage. But, while this sounds good, the truth is that this actually reduces the savings because your payment amount is now computed on a bigger loan amount, therefore increasing your monthly payment. The other issue here is whether or not your house will appraise high enough to allow the buy-down cost be added to your loan. Remember that the amount of the loan cannot be more than the appraised value, (with the exception of the government insurance premiums that can be added to FHA, VA, and USDA rural loans).

Temporary buy-downs, such as the 2/1, can make sense for a young couple for example, just entering the job market with the expectation that their salaries will increase over the 2 years the rate is adjusting.  The rationale here is that the higher payment will be more manageable at a later time.  This was popular during the housing boom, when prices were rising faster than incomes could catch up, but it's unlikely we'll see a boom like that anytime soon.

 Banks justify the cost of the buy-down because of additional paperwork required. The cost of a buy-down is always computed to the banks advantage, not yours.

So why do we keep hearing so much about buy-downs? Why do so many people think this is such a great idea? Remember that when you are looking for a house, you usually determine the “amount you can afford” based on your comfort level with the payment amount. If you can lower your payment, you don’t care about the cost.

If your lender is not discussing the cost of the buy down with you in the above terms, and helping you compute your break-even point, perhaps you should be talking to another lender.

Good luck out there.

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Shelby