When preparing for your home purchase and the subsequent financing that goes with that large purchase, you may consider buying down your interest rate. This process will cost you in the beginning, but compared to the life of the loan and what you'll save on interest may be well worth doing. The process is relatively simple and basically involves you working with your mortgage broker or loan officer, letting them know what rate you would like to get and they'll let you know, based on the loan amount and the going market rates what it would cost you to "buy down" the rate to your desired rate.
Here's a brief example of how this would be done:
Most mortgage rates can be bought at an approximate rate of .25% of the loan amount in fees for a .125% decrease in your rate. Of course this number increases the further away you get from that par rate to where each subsequent drop in .125% of the rate will cost you more proportionately.
If the "par rate" is 5.5% and you would like to get a rate of 5.25%, you would need to buy down this rate. A rate sheet which you can obtain from your mortgage broker would include the following information:
5.625% - -0.375 5.5% - 0.00 5.375% - 0.25 5.25% - 0.50 5.125% - 1.00 5.00% - 1.75
The number on the left is interest rate for the loan and the number on the right is the cost of buying that interest rate as a percentage of the loan amount. The closer the interest rate gets to 0, the higher it will actually cost you to buy down the interest rate. So, there is a point where it will not make sense to do based on your cash availability. In our example, you would have the following:
5.5% is the par rate and if you were to want to buy down the loan to 5.25%, it would cost you .5% of the loan amount. With an example of a $200,000 loan amount, in order to reduce your rate from 5.5% to 5.25%, you would have a $1,000 ($200,000 x .5%) buy down for that decrease in rate. For this calculation, you would have the following monthly payments:
5.5% - monthly payment: $1,135.58 - total of 360 payments: $408,808.08 5.25% - monthly payment: $1,104.41 - total of 360 payments: $397,586.67
Over the life of the loan, your payment of $1,000 to buy down this loan would save you $11,221.41. Now, this may seem like a lot of money and a good return on investment. Just as a comparison, if you were to invest this same $1000 with a 6% annual interest rate, after 30 years you would have $5743.49. Of course, if you found something more aggressive, at say 12% annual interest rate, after 30 years you would have $29,959.92. So, somewhere in the middle of those two numbers is about what you would save by buying down your rate.
Consult with your loan officer or mortgage broker about this as a possibility and if nothing else, know your options. If you're one of those that wants the "no point mortgage" or "no cost loans" you'll probably be looking at the percentage higher than par based on these calculations. This buy-down of the loan works well for those who have availability of funds and for those who can use this as a financial tool.