When a borrower chooses a mortgage to purchase or refinance a home loan, they have some flexibility in choosing the ultimate rate they receive. One option is a rate buy down, which lowers the interest rate and the monthly mortgage payments.
By far the most common way to buy down the interest rate on a mortgage is buying "points," which refers to a percentage point of the total loan amount. If a lender's mortgage rate is 6% with zero points, and a borrower wants a mortgage at 5.75%, the cost is one point. By paying for points, it is possible to buy down the current mortgage rate by up to a full percentage point. Buying points to lower the interest rate will result in a lower mortgage payment.
Buying two points to buy down the rate on a $300,000 home loan would cost $6,000. If this lowers the mortgage rate from 6% to 5.5%, the monthly principal and interest payment drops from $1,799 to $1,703 per month. This results in a savings of $96 per month.
Before deciding to do a rate buy down, compare the monthly savings to how long you plan to own the property. In this example, it would take 63 months, or more than 5 years, before the savings are equal to the cost. A rate buy down makes the most financial sense when you plan to stay in the home for a long time.
In some cases, the cost of points can be rolled into the mortgage, but this further reduces monthly savings and alters the loan-to-value ratio, which may increase other costs.
How a Mortgage Buy Down Works
A rate buy down does not involve negative amortization and it is usually more advantageous than choosing an adjustable rate mortgage with a payment option that allows negative amortization, such as an Option ARM. With a mortgage buy down program, the mortgage payment will always include principal and interest payments, so making monthly payments will always reduce the mortgage balance.
One option for reducing mortgage payments involves reducing payments and determining a lower interest rate over a specific amount of time. The difference between the "real" rate and the lowered rate is paid in cash by the borrower or the home seller.
Another option is the 3-2-1 mortgage buy down, which is a 30-year mortgage with an interest rate that increases 1% per year for the first three years. The interest rate remains fixed for the rest of the term.
A 3-2-1 mortgage buy down comes with some advantages. Rather than paying a single high payment all at once, the payment increases in smaller increments at first. Payments are kept low for 36 months for borrowers whose income is expected to rise.
In some cases a 2-1 buy down program may also be used. This option provides a 30-year mortgage with an interest rate that increases 1% every year for two years, after which the interest rate is fixed for the remaining term of the loan.