Rates hovering in the 6% range have a lot of buyers in an affordability crunch.  Prices aren’t coming down like most had expected and are even going up in some price ranges.  Buyers are between a rock and hard place and trying to find ways to better afford the mortgage payment.  I am getting questions about the benefits of paying points to buy down the mortgage rate, so I wanted to explain how that works and when it does and doesn’t make sense to use that strategy.

Paying points is a general term for paying more money up front to buy down your mortgage rate which in turn gives you a lower payment than a higher rate with no or fewer points.  By definition:  1 point is equal to 1% of your loan amount. So, 1 point on a 500K loan would be $5000 paid as part of your upfront closing costs.  The number of points you pay can be more than 1% or less than 1%. It is not always an exact number to get to the next lowest rate or to a rate that is a lot lower.  The number of points you pay will depend on the pricing scale on the date your loan is locked.

For example, let’s say the rate for your 500K loan without paying any points on that date is 6% even.  You may have the option of paying .5 points ($2500) to get to 5.875% and maybe it would take 1 point ($5000) to get to 5.75% but if you wanted to get all the way down to 5.5% it would cost 3 points ($15,000)

The principal and interest payments at 6% would be $2997.75, 5.875% would be $2957.68, 5.75% would be $2917.86 and 5.5% would be $2838.94.

To see the monthly savings of paying the points you simply deduct the lower payments from the no point 6% payment of $2997.75 to see what your up-front investment bought you.

At 5.875% $2500 bought your payment down $40, at 5.75% your $5000 bought your payment down roughly $80.  At 5.5% your $15,000 bought your payment down $159.

The next step is to divide the savings into the up-front cost to see how many months of the lower cost it will take to equal the up-front investment.

$40 a month in savings will reach the $2500 investment in about 63 months or just over 5 years. It takes about the same amount of time for the 5.75% savings of $80 to equal the upfront investment.  For the $15,000 buydown to 5.5% it takes longer, almost 8 years.  From this hypothetical example, you aren’t getting as much of a benefit for spending that large amount to buy the rate down to 5.5%, so let’s look at the two other options.  Both the 5.875% and 5.75% buydown options break even at 63 months, so here is where we need to make some decisions.  Will you be in that house longer than 63 months?  Will you be in that same loan longer than 63 months?  Historically homeowners have stayed in their homes for an average of 7 years, so let’s assume yes, you will be in that house for at least 7 years.  In that case it would make sense to buy down the rate (assuming you have the money to do so) since you would be ahead on savings every month beyond the 63^rd month.

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So, assuming you will keep the home longer than 63 months the big question is, will you be in that same loan for longer than 63 months.   If you refinance that loan after a year or two, you now lose the benefit you paid for. You paid money up-front for monthly savings you didn’t receive for the amount of time you needed to break even on the up-front investment. If someone who needed to keep a loan for 63 months or longer to break even, refinances or sells that home before that, the benefit is lost.  In these cases, the borrower would have been smarter to just put that upfront money aside and pay the extra amount monthly for the 1-3 years they had that loan before they sold or refinanced.  $40 more a month for 3 years is only $1440 so the borrower would have saved about $1000 not putting that money into buying down the points.

Rates are expected to come down, but it’s not guaranteed, but if they do come down to the low 5s or even dip back into the 4s in the next 1-3 years, a lot of people who paid upfront money to buy down their rate will lose the expected benefit of those buydowns.  If for some reason rates stay elevated or go even higher, those that paid points will be happy they did, as long as they don’t make any changes to their bought down loan.

It’s important to run the numbers and see what the upfront money buys your rate down to, and how much that will save you.   When is the breakeven point?  If it’s a year or two, (maybe even 3) then maybe it makes sense, but if the break even point starts stretching into the 5 years and beyond point, it may not make sense to spend the money up front.

The numbers I used are pulled out of the air to make this example.  The rate scale for your loan at the time you lock a rate may be very different, and we can discuss those options using this same logic.  I just wanted to break it down, so you understand the method and strategy behind paying points to buy your rate down.  Sometimes it makes sense and sometimes it doesn’t.