Should I pay discount points on my mortgage loan to get a lower interest rate?
Ryan Tanel
Offering Passive investments in multifamily apartments for Top Producing Realtors, Loan Officers, and Real Estate Investors
Investors,
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My name is Ryan Tanel with Top Producer Investment Capital.? I own and oversee 225 C Class value add apartment units across 7 properties in Central Texas with an emphasis on renovations, and quick fix and flips to maximize LP IRR.? We syndicate deals with investors to allow the average investor to diversify their portfolio with passive cashflowing real estate investments.
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Because interest rates are really high these days, a lot of sellers, new home builders, and lenders are offering incentives to purchase homes in the form of interest rate buy down as a form on seller/lender paid closing cost.? Financially speaking, how does the math play out on if this is a good idea or not? When does it become a good idea?
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There are 2 versions of this buydown.? You can do a permanent buydown where you pay up front discount points for a reduction in your total interest rate.? For example, paying 1 discount point (1% of your total loan amount as “prepaid interest” or a closing cost at closing) in exchange for lowering your rate by say 0.25%, or a temporary rate buydown where you pay 0.25% of your loan amount in exchange for a 2% reduction in your interest rate year 1, and a 1% interest rate reduction year 2, then it resumes your normal interest rate year 3 and beyond.
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For this article I’ll just talk about 30 year fixed conventional mortgages on primary residence home purchases since that likely applies to most people, but these concepts apply to all types of mortgages; VA, FHA, commercial, hard money, 15, 20, 25 year terms, ARMS, etc.
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So is it a good idea to pay these closing costs in order to receive lower interest rates??
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TLDR: No, it is almost always NOT a good idea to prepay discount points in exchange for a lower interest rate, and I’ll explain why.
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First, let’s talk about why these things even exist in today’s world anyways. ?Like anything, lenders selling mortgage loans wanted to sell more loans to the public by “appearing” like a better deal through good marketing tactics.
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Mortgage company A was getting bummed that they were more expensive (had to offer at 5% interest rate to stay profitable) than mortgage company B who was currently offering a 4% interest rate. ?Mortgage company A wanted to appear competitive, but still make just as much total profit as before, so they started offering this interest rate buydown option.?
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They basically said for an extra $1,000 of closing costs, you can get a 3.75% interest rate.? “See! We are better than mortgage company B.”? The trouble was, they put the extra closing cost at the bottom of the page where the total to bring to closing was lumped in with the down payment.? Since it all just looked like a ton of money to the home buyer, they focused on the big number at the top.? The 4% interest rate without considering the closing costs, 3.75% looks better, since its over a 30 year time horizon, and lower is always better right?
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The good loan officers (like me) would disclose these differences in costs to get a lower interest rate, but there were a lot of loan officers who would try to hide it in order to close a sale to someone who didn’t understand how mortgages worked (most people).
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Because of this, the government created the term APR % (annual percentage rate), which is different than interest rate %.? APR includes closing costs as an expression of the interest rate, where as the flat interest rate does not include closing costs.?
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The way to calculate APR is to add up all the closing costs, and all the interest paid in year 1.? Express that total as an interest rate, and you get APR.?
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For example, if I am getting a $100,000 mortgage, and the interest rate is 1% ($1,000 of interest paid out year 1), and my closing costs are $2,000, then the total I am paying in the first year is $3,000 ($2,000 of closing costs + $1,000 of interest).? $3,000 is 3% of $100,000, so my APR is 3%, but my interest rate is 1%.? See the difference?
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Now you can see when 2 companies have the same interest rate but different APRs, its because of the closing costs.?
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Okay, so now let’s figure out the math on if these things are a good idea.
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Here is a real world example of loans I would do all the time.? A $200,000 loan would have these options:
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6% interest rate at par (0 discount points)
$12,000 of interest per year, 0 additional closing costs.
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5.75% interest rate a 1 discount points
$11,500 of interest per year, $2,000 closing cost
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5.5% interest rate a 2 discount points
$11,000 of interest per year, $4,000 closing cost
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5.25% interest rate a 3 discount points
$10,500 interest per year, $6,000 closing cost.
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5% interest rate at 4 discount points.
$10,000 interest per year, $8,000 closing cost.
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You can see the trend.? For each $2,000 of additional closing cost, you get to save $500/year on interest.? These options also work in the reverse, offering higher interest rates in exchange for credits to pay other closing costs.
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6.25% for 1% lender rebate
$12,500 interest per year, $2,000 credit on closing costs
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6.5% for 2% lender rebate
$13,000 interest per year, $4,000 credit on closing costs
?Etc.
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The quick math would say that yes, over the course of 30 years on my mortgage, saving $500/month is a good idea.? That comes out to a savings of $180,000 over 360 payments. ?If it only costs $2,000 it’s a great idea!
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That is the sales pitch we would use to help people see that it was a good idea to use the lower or interest rate based on their goals.? It helps clients keep the decision between which interest rate do I want to choose instead of should I use mortgage company A or B.
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Let’s get back to the real world.? When was the last time that you knew someone who lived in their house making minimum payments, never refinancing, never selling, for 30 years?? Almost never.? The average person sells their home after 7 years.
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Nowadays with people being more mobile, it may be common to buy a house, live in it 3-4 years, and then sell it to move to a higher paying job in another city.
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With how volatile interest rates are, people are often refinancing in order to get a lower interest rate.
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With my example above, let’s say you do the 5% interest rate for $8,000 of closing costs, because it will save you the most money over the life of your loan.? In 2 years from now when interest rates go down to 4%, are you going to want to refinance your loan?? Definitely.? It’s the smart thing to do.?
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The math says you paid $8,000 in closing costs, but only “Saved” $4,000 in interest over those 2 years.? Your extra $4,000 was paid as a closing cost, then lost when you refinanced.
Let’s say you don’t refinance the house or sell it.? You keep the house 7 years, like our parent’s average length of ownership.? 7 years is a long time.? Think about what you were doing in your life 7 years ago and how much about your situation has changed since then.? It’s a lot right?? You’re probably in a better financial situation overall and can use that money for other things now.
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That $8,000 could have been invested in the stock market getting an 8% rate of return (or with a multifamily syndicator getting 15% rate of return).?
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Let’s say you put it in the stock market.? With compound interest at 8%, over 7 years, your investment has grown to $13,710.? You’ve earned $5,710 of profit through investing in the stock market.?
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If you had paid $8,000 to get the lower interest rate, you would have saved $2,000/year.? After 7 years, you saved $14,000 of interest, but paid $8,000 to get that rate, so $6,000 of net savings.?
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Your investment basically broke even compared to investing in the stock market after 7 years of home ownership, the typical length before someone would sell.?
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If you think about how long 7 years is, do you think it is likely you will refinance? Sell?? Have a need for that liquidity to be accessible instead of stuck in the investment of an interest rate buy down?? Is it possible you’ll get higher than 8% rate of return on your investment somewhere else?
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Keep in mind, 7 years is just the breakeven point.? You’ll have to keep that same loan 8+ years to start having that choice become profitable compared to investing in the stock market.
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(By the way, this same logic applies to putting a higher down payment on your home.? If you are putting 20% down instead of 5% down to save 0.5% of mortgage insurance payments, your opportunity cost of not investing that money in the stock market is 7.5% loss on your extra down payment.? A $2,625 difference / year on a typical $200,000 home between what you saved by not having mortgage insurance, and what you could have gained by investing at 8% with stocks).
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So, to sum it all up, right now since interest rates are likely to go down in the next 2-5 years, it is likely you will either refinance or sell when they do.? If a lender, new home builder, seller, etc. is offering you that “They will pay $20,000 to buy down your rate to 5.0%” or whatever, just ask them to take it off the purchase price of the home instead.? It’s a way better use of your money to get a cheaper home than a cheaper rate considering you won’t have that loan long enough to take advantage of the benefits of the lower interest rate.
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I personally have always opted to get the lender credit rebate in exchange for a higher interest rate, and I have always put the minimum down payment on a house, even though it makes the payment on that house higher, because I know I can reinvest my money in the stock market (or multifamily syndication) for a far greater rate of return than the savings I’ll get on that additional down payment.
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I know it hurts the ego and the brain to think about a higher interest rate, or a higher total payment as being better from doing this method, but by the math it is a better financial decision to have a higher interest rate and a lower total house cost or more money in the bank so you don’t miss out on other investments.
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If you don’t like risk, and want to make minimum payments on your loan that you keep for 10-30 years, I guess go with the lower interest rate.? But for the average person, it’s a bad deal to take the lower interest rate deal.
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Here is a discount point calculator if you want to see the math yourself: https://www.mortgagecalculator.org/calcs/discount-points.php
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For more information on our portfolio, investing strategy, or to learn more, check us out: www.topproducerinvestmentcapital.com
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