How to break down the pros and cons of buying down interest rates

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Buying down interest rates (also known as buying points) may seem counterintuitive to many people. After all, why would a homebuyer willingly commit to bringing more cash to the table at closing or sign on for a larger loan?

In fact, there are some excellent reasons buying down interest rates is worth considering — and a few reasons why it might not be such a great idea. It’s up to agents to help clients understand which side they fall on by explaining the important pros and cons. 

What are points, and why buy them?

In the simplest terms, buying points means paying a fee at closing that reduces the interest rates on a mortgage. Typically, each point costs 1 percent of the total loan amount, making them more expensive on higher-priced properties. For example, each point on a $200,000 mortgage will cost $2,000, while they’ll cost $4,000 per point on a $400,000 loan. 

How much buying points will lower your rate will depend on the lender and your unique circumstances, so it pays to compare offers from different lenders. While one lender might lower your rate by 0.25 percentage points for each point purchased, other lenders might offer a bigger or smaller rate reduction.

When comparing offers, the Consumer Financial Protection Bureau recommends asking for the same amount of points from each lender. Points don’t have to be round numbers — you can pay for fractions of a point, such as 1.375 points or 0.125 points. 

Some buyers pay for points upfront, writing a check at closing, while others roll the cost into the mortgage loan. Each is workable, but adding the cost of points to the mortgage means that you will also pay interest on them for the life of the loan, reducing a buyer’s potential savings.

Discount points are not to be confused with origination points. Origination points are fees charged by the lender for creating the loan. They’re simply another closing cost that doesn’t impact long-term, recurring costs. 

Points listed on the borrower’s loan estimate and closing disclosure must be connected to a discounted interest rate.

How much buying points can save

If reducing an interest rate by one-quarter of a percent doesn’t sound like much, consider this: On a $200,000 mortgage, the difference between a 7 percent and a 6.75 percent mortgage payment is about $33 monthly. This might sound relatively insignificant, but the long-term savings are substantial.

On a 30-year mortgage with a 7 percent interest rate, clients pay just over $279,000 on interest alone. With a 6.75 percent rate, they’ll pay just over $266,000. That’s a net of $11,000 in savings over the life of a loan from just $2,000 upfront. 

There is no official limit to how many points clients can buy at closing, but many lenders won’t sell more than four. For that same $200,000 loan at an original 7 percent rate, four points would cost $8,000. By reducing the interest rate by 2 percent, buyers will spend more than $92,000 less on interest over 30 years than they would otherwise. 

Calculating whether points are worthwhile comes down to whether clients plan to be in their homes long enough to recoup their investment and start reaping savings. 

Pros of buying down interest rates

For many clients, spending a little extra at closing is an excellent idea.

Here are four pros of paying points:

1. Monthly payments are lower

A lower interest rate means lower monthly payments over the life of the loan. If clients are looking for more cash flow and less of a monthly burden, this can make payments more manageable. It also frees up income for improvements and maintenance, which are essential if the property is an investment to flip.

2. Less interest paid over time

Paying points is a positive strategy if your clients are looking for their forever home. A reduction in the monthly mortgage payment of just $30 or so may not seem much, but stretch it over the life of the loan, and the savings are substantial.

3. More tax deductions

Mortgage points may be tax deductible, which offsets some upfront costs and can offer financial relief at tax time. Remember that tax rules are complex, and not all homebuyers can take advantage of this benefit. Advise your clients to consult their tax professional if they have questions about their personal tax situation. 

4. Loans may be more affordable

In a tight market with inventory still relatively low, many buyers find themselves in the uncomfortable position of stretching their monthly budgets to make a competitive offer. In this case, buying down interest rates can help ease that tension. This flexibility is also ideal for anyone looking to move to a larger property or to be more competitive in the bidding process.

Cons of buying down interest rates

Not everything falls in the positive column when it comes to buying points.

Here are three cons to share with your clients:

1. Clients pay more at closing

The upfront cost increases the initial total cost of the loan, which means the amount due at closing can be larger than expected. This expense can be burdensome for clients who need cash for down payments, moving expenses or other closing costs.

2. It takes a bit to break even

Recouping the costs of paying points typically takes several years at a minimum, with the exact break-even point depending on the loan amount, the number of points paid and how much money clients save on their monthly payments. If clients sell or refinance too soon, some or all of the benefits are wasted.

3. Risk of unexpected changes

Even if clients plan to stay in their homes well past the break-even point, predicting the future is impossible. Unexpected life changes, from a job change to a death in the family, can cast even the best-laid plans aside and force clients to move or refinance. There’s no need to dwell on potential disasters, but it is vital to let clients know they may lose the advantage of points in these unfortunate situations. 

Should your clients buy down interest rates?

As mortgage rates increased in 2022 and 2023, the proportion of homebuyers paying discount points doubled, according to studies by the Consumer Financial Protection Bureau and Freddie Mac. Last year, nearly 2 out of 3 borrowers taking out purchase loans paid points to lower their rate. 

While discount points are often paid by the borrower, homesellers and homebuilders may also offer to buy down the homebuyer’s interest rate. These incentives are often offered in the form of temporary rate buydowns that only last one to three years.  

Not every client will benefit from buying points. But with 70 percent of homesellers worried that higher interest rates will deter buyers, it’s critical for real estate agents to give homebuyers all the tools they need to make informed decisions about them.

While buying points can sometimes represent a significant upfront cost and come with risks, they can also make owning a home much more affordable in the long term. If clients are still unsure, a financial advisor can offer more concrete advice based on their specific situation.