When should you buy down your interest rate?
Most people who are shopping for a mortgae cringe at the thought of paying points. Few realize that there are points out there that can save you thousands of dollars over the life of your loan.
The Three Types of Points
In explaining points, it is important to note that there are three kinds of points that can be charged on a loan.
First, you have what I like to call Operational Points. These are points that can be charged in order to pay the person who is working on your mortgage for their time (Example: Origination Points).
The second type of points are Risk Based points. These are charges the lender can add to your costs based on how risky of an investment your loan is (Examples include low equity, bad credit, investment property, stating income, etc.)
The third type of points are commonly known as Investment Points. It is important for potential borrowers to understand that these points can actually save you money over the life of your loan, thus commonly referred to as "good points" since they actually benefit the borrower.
Leveraging Your Equity
When buying down an interest rate, what you end up doing is using the equity that is locked up in your home to lower your interest rate as well as your monthly payment. Since the rate of return of equity is essentially 0% (see Gregory Wilder's article entitled "Should you leverage your home?" for a much more detailed explanation of this) we can utilize some of this stored up cash to invest in a cheaper interest rate from the lender. Typically you can obtain about a 1% cheaper interest rate in a 30 year fixed mortgage by paying the lender roughly 4 points, or raising the loan about by about 4%, thus investing some of your equity.
Reaping The Rewards
Even though we lost some equity in the above transaction, it is important to look at the average rate of appreciation for real estate in your area. Even with the drop in property values that we have seen recently, there are still many markets in the US that are on the rise. In most cases, the rate of appreciation for your home will offset the equity investment you make to get a lower rate in less than a year.
EXAMPLE: A homeowner refinances a $300,000 mortgage on her home in Albuquerque, New Mexico that is valued at $400,000 (equity = $100,000). She pays 4 points to get her rate down. Her new loan amount would be $300,000 (closing costs, say $2,000) (4 points, AKA 4% * $300,000) = $314,000. In this example, the homeowner invested $12,000 of her equity in order to buy down the rate. The 2006 average appreciation rate for residential property in Albuquerque was 13.6%. Assuming this trend continues for the next 12 months, her home would be worth $452,000, making the equity after one year $138,000 -- a net increase of $38,000!
The borrower also reaps a substantial savings over the life of the loan in the amount of interest paid. In the example above, a change in interest from 7% to 6% on a 30-year fixed would save her $57,589.
Calculating The Break-Even
Determining whether buying down an interest rate makes sense depends on how long you plan on being in your home and in the same mortgage. Buying down a rate makes less sense if you either a) plan on moving out of your home in the near future, or b) expect interest rates to fall and plan on re-financing. Although the latter is a bit harder to predict, the first can be calculated fairly easily. Simply take the added cost of buying down the rate and divide it by the incremental benefit. In the case above let's say our monthly payment was lowered by $200 by getting into a lower interest rate. We could simply divide 12,000 by 200 and come up with 60. This means it would take 60 months or 5 years of incremental savings to offset the extra equity investment, not taking property value appreciation into account.
Conclusion
Should you buy down your rate? This question should be a little easier to answer now that you understand the costs and benefits involved. Figure out your own situation and you could save thousands in the long run.
CONTRIBUTORS
Should you leverage your home?
Should You Leverage Your Home or
Pay It Down Rapidly?
There is a great debate within the inner-mortgage circles these days. Should loan professionals encourage clients to borrow as much money as possible? Or would consumers benefit more if they understood the advantages of 15-year amortization schedules and pre-paying principal? Let's examine the pros and cons of both strategies.
Leveraging Your Property. In order to understand why you'd want to borrow as much as possible for your home purchase, you must first grasp the concept that equity has a zero rate of return. Here's an example:
If Consumer "A" buys a home for $300,000, and puts 20% down, then they have $60,000 in equity. Over the next 5 years, the property appreciates $100,000 in value. Consumer "A" now has $160,000 in equity.
Consumer "B" buys a home for $300,000, and puts no money down. At the end of 5 years, that same home is now worth $400,000. Consumer "B" has $100,000 in equity, which is the same appreciation as Consumer "A", a net $100,000.
As you can see, your down payment has nothing to do with your rate of return. What becomes important is how you choose to manage the $60,000 you didn't use as a down payment. If you use it for frivolous activities, such as buying toys or going to Las Vegas, it would be more prudent for you to use that money as a down payment. Especially since this will enable you to obtain a lower interest rate.
However, if you were to invest the $60,000 in a vehicle that can out-earn the cost of that debt, then this could be a formula for success. This is why some lending professionals suggest putting as little down as you possibly can, maximizing your tax write-off, and investing the rest. This principle has been applied for many years in the life insurance game. The old saying goes, "Buy term and invest the rest." The key component is taking the money you would have used as a down payment and creating an asset accumulation account. This account should earn a significant enough rate of return to enable you to pay your mortgage off entirely and achieve the ultimate goal of being debt-free.
Paying Your Home Down Rapidly. There are very few times over the course of my career that I have seen a client with zero debt and no financial difficulties. Choosing to pay off all of your debt can reduce stress and help you to gain freedom of cash flow for investment opportunities. A 15-year mortgage or a bi-weekly payment strategy provides structure. It can also put you on track to have your mortgage paid off within a set timeframe. Simply put, it contains built-in discipline.
It's important, however, to understand that regardless of how rapidly you pay your home off, you're not getting any greater rate of return on your investment than if you paid it off slowly.
Conclusion. So how does one determine which scenario is best? The choice depends entirely upon the individual. Savvy consumers who are disciplined, and are comfortable taking chances from an investment perspective, would do well with the first scenario. Over the course of time, it's been proven that your rate of return over the long-haul will be far greater than the rate you'd pay for a mortgage in today's rate environment. It's important to seek the advice of a skilled investment advisor to ensure success with this strategy.
The second scenario is best for those who have a difficult time managing their money or who'll sleep easier at night knowing they have a plan in place to pay their loan off more rapidly. Be sure that your budget can handle accelerated payments. When consumers "bite off more than they can chew" with a 15-year mortgage, they frequently end up having to refinance back into a 30-year schedule.
If you find this subject intriguing and would like to know more, recommended reading is Missed Fortune 101, by Douglas Andrew. It's an outstanding read that is very simplistic and goes into far greater detail than this article.