How buying down your interest rate helps save you money

There are a few ways to lower the cost of your mortgage, but one option you may not know as much about is buying down the interest rate. If you have some extra liquidity, this can be a great option to save some money either temporarily or permanently.

During the COVID-19 pandemic, low mortgage interest rates helped fuel a hot housing market, with many people buying their first homes. If you purchased or are considering purchasing a home outside of that period, however, higher interest rates may present challenges to your budget. High mortgage rates mean higher monthly payments, which can make life difficult if you’re looking for a home since you don’t have as much buying power. 

Buying down your interest rate will enable you to make a lower monthly mortgage payment. But other times, it might make more sense to make a larger down payment or make extra payments to try to pay your mortgage off earlier, depending on your situation. Better yet, you could refinance when interest rates get lower in the future.

What does it mean to buy down the interest rate?

Buying down the interest rate is a way for a borrower to obtain a lower interest rate by paying for mortgage points at closing. Also called discounts points or prepaid interest points, these points are basically a fee you pay upfront to lower the interest rate for the term of the loan.

You can buy down the interest rate for the entire term of the loan or for a given amount of time at the beginning of the loan. This makes the borrower’s monthly mortgage payments more affordable for a period of time. At closing, you pay an amount that covers the difference between the standard interest rate and the lowered rate, effectively raising your upfront closing costs in exchange for long-term interest rate savings. Buying down the rate is a useful strategy when interest rates are high, or when they’re forecasted to rise, making it harder to refinance for a lower rate.

How does an interest rate buydown work?

You can buy down your interest rate either permanently or temporary. Terms are negotiable from lender to lender and every scenario depends on your personal financial situation.

A permanent interest rate buydown is more expensive upfront and lowers the interest rate for the entire term of the mortgage, usually 15 or 30 years. The more points you pay for, the more you can reduce your mortgage rate. (Although if you take out an adjustable-rate mortgage, the rate may increase at some point during the mortgage term.)

In a temporary buydown, borrowers negotiate an initial rate with their mortgage lender. You can get a buydown plan with rates up to 3% lower than usual, but rates will rise each year based on the plan you choose. Then, the final rate is fixed for the remaining loan term. 

There are three temporary buydown structures, covered below.

1-0 buydowns

One of the most common buydown structures used by lenders, 1-0 buydowns are the shortest term buydown available. The temporary buydown makes your interest rate 1% lower for the first year than when it would be for the rest of the loan term. Here's an example:

• Year 1 of mortgage: 6% interest rate
• Year 2-30 of mortgage: 5% interest rate

Some lenders offer this type of buydown for free to incentivize prospective homebuyers to borrow from them.

2-1 buydown

A 2-1 buydown is essentially the same, except it buys down the interest rate by 2% the first year, then 1% the second year. So, if you had a 5% interest rate, you would pay just 3% in the first year of the loan, then 4% the second year, and 5% for the rest of the loan term. 

• Year 1 of mortgage loan: 4% interest rate
• Year 2 of mortgage loan: 5% interest rate
• Year 3-30 of mortgage loan: 6% interest rate

This type of buydown will always cost discount points upfront.

3-2-1 buydowns

Like the other types of buydowns, a 3-2-1 buydown is one that allows a buyer to pay less interest for three years after obtaining a loan. 

So, following the previous model, if you had a 5% interest rate, the points you buy would lower your interest rate to just 2% for the first year, 3% for the second, 4% for the third, and 5% for the remainder of the loan.

• Year 1 of mortgage loan: 3% interest rate
• Year 2 of mortgage loan: 4% interest rate
• Year 3 of mortgage loan: 5% interest rate
• Year 4-30 of mortgage loan: 6% interest rate

The amount charged for discount varies by lender but, generally, the more you pay upfront for a 3-2-1 buydown, the more you save on interest in the long run. Talk to a financial advisor to see what buydown structure works best for you. When you buy a house with Orchard, you'll also have the opportunity to get loan — and buy down the rate — with Orchard Mortgage.

How much does it cost to buy down interest?

The cost to buy down the interest rate varies based on the lender and on how much you take out on the loan. Each discount point that you buy is equivalent to 1% of the loan amount, but different lenders offer different points.

For a mortgage loan amount of $350,000 the cost of a mortgage point would be $3,500. That may sound like a lot but it could equate to thousands in savings in the long-term. One point will typically reduce your interest rate by 0.25%, so if you want to calculate how much it cost to reduce your interest rate by 1%, then multiply your loan amount by 0.04 (to find out what 4% is). Here's a breakdown of the new rate you'll get from a buy down.

Example: Calculating interest rate from a buydown

Who can buy down the mortgage interest rate?

While buyers benefit from interest rate buydowns, they aren’t always the ones who buy down a mortgage interest rate. The home seller or builder can also get involved in a rate buydown.

Most buydowns are negotiated between buyers and lenders as buyers are the ones paying back a mortgage. However, sellers may also buy down a buyer’s mortgage to incentivize the buyer to follow through with a home purchase. When this happens, the seller makes a one-time deposit into an escrow account as a concession to the buyer. This subsidy gives the lenders the necessary funds to lower the buyer’s interest rate. However, many sellers will then raise the purchase price of their home to offset the cost of buying down the buyer’s mortgage.

Builders will sometimes do the same thing. After building a new community, buying down interest rates is an effective tool to lure buyers to purchase properties. If they’re flush with interest in the community, however, it’s far less likely, but it never hurts to ask.

Paying for an interest rate buydown

You can pay for an interest rate in one of the three ways: 

• Cover the cost yourself: Paying yourself is as simple as paying the lender a lump sum when you close on your mortgage. If you’re receiving a mortgage gift from a family member or friend, you could apply the funds to a rate buydown, too.
• Ask the seller or builder to pay for it: If the seller pays, they’ll put the money in an escrow account for the lender to access to cover the interest costs. Additionally, some builders will give you extra incentive to use an “in-house” mortgage company.
• Finance it into your loan: You can roll the costs into your mortgage so you don't have to pay for a buydown upfront, but you'll be starting off with less equity in your home since you're taking on a larger loan amount.

Should you buy down your mortgage interest rate?

Buydowns are a no-brainer if a seller or builder offers to buy points on your behalf without significantly increasing the home’s purchase price. If you’re buying the points yourself, however, you have to analyze your financial situation.

If you’re stretching to cover your desired down payment and closing costs, trying to buy down your interest rate may be too much. You want to make sure you're in the best position to be able to afford your monthly mortgage payments, which include interest and private mortgage insurance if you put down less than 20%.

But if you have a cushion of several thousand dollars in your budget, it might be worth getting a discount on your mortgage payments, even for just the year or two— especially if you expect to have a higher income in the future. Buyers like graduate students moving into their first home or stay at home parents who expect to return to the workforce in the coming years might benefit from buying down their interest rates.

3 situations where you shouldn't

• You plan to refinance before reaching the breakeven point. If you expect mortgage rates to drop in the future, then you may be better off just waiting to refinance instead of buying points.
• You plan to sell the house soon. If you sell your house soon after buying it, not only will you fail to recoup the costs of the buydown, you could also lose money on the house and face additional tax consequences. 
• You can’t afford it in the first place. Rate buydowns can help you save money, but they’re not cheap. If you don’t have the cash on hand to make it work, it may be better to rethink how to use the money you do have, which may be better served towards putting more money down or saved ahead of time for future, or extra, mortgage payments.

If you decide a rate buydown isn't in the cards, you can still try to get a lower interest rate a few different ways: Make sure you have a good credit score and low debt-to-income ratio, and shop around with different lenders to find the best rate. When you buy a house with Orchard, you can use Orchard Mortgage to lock the best rate, buy down your interest, and, get no-fee refinancing for life.

Finding the breakeven point

Understanding if it’s worth buying down your interest rate is all about calculating your breakeven point. This is the amount of time it will take to recoup the upfront cost of discount points required to lower your interest rate. This is the formula:

Breakeven Point = (The Cost Of Points)  ∕  (Monthly Savings)

For example, let’s return to that $350,000 mortgage with a 5% interest rate. We’ll assume it’s a 30-year fixed mortgage and your lender charges you four points to reduce your interest rate by 1%. The cost of buying four points is 4% of your total loan amount, or $14,000.

At a 5% interest rate, your monthly payment would be $1,879. At 4%, it would be $1,671. That’s a monthly savings of $208. (Use a mortgage calculator to figure out your monthly payment.)

Divide $14,000 by $208 and you get 67.31, meaning the breakeven point is 67 months. That’s five years and seven months to recoup the value of the interest rate buydown.

If you, as the buyer, think there’s a chance you’ll sell the home or refinance before the 67-month mark, a buydown wouldn’t make sense for you. Instead, you’d want to think about making extra payments, as you can also save money on interest by paying off your mortgage early.

FAQs

Here are more answers to your pressing questions about how to buy down interest your interest rate.

Q: Can I buy down an interest rate?

Yes, it is possible to buy down an interest rate. Buying down an interest rate involves paying an upfront fee or mortgage points to reduce the interest rate on a loan, typically a mortgage. By paying this fee, borrowers can lower their monthly mortgage payments over the loan term.

Q: How much does it cost to buy down 1% of your interest rate?

The cost of buying down 1% of interest varies based on several factors, including the loan amount, the current interest rate, and the specific terms set by the lender. Typically, buying down the interest rate by 1% would require paying points equal to 1% of the loan amount. For example, on a $300,000 loan, buying down the rate by 1% would cost $3,000 (1% of $300,000). However, it's important to note that these figures are general examples, and the actual cost can vary from lender to lender. You should always consult with your lender or mortgage broker to get an accurate cost of a rate buydown.

Q: Is it smart to buy down your interest rate?

Whether it is smart to buy down your interest rate depends on your specific financial situation and goals. Buying down the interest rate can be beneficial if you plan to stay in the home or keep the loan for a long time. It can lead to substantial savings over the life of the loan, especially if you secure a lower interest rate for the long term. However, if you plan to sell or refinance the property within a few years, the upfront cost of buying down the rate may not be worth it.

Q: Can buying down the interest rate be tax-deductible?

In general, the points paid to buy down an interest rate are tax-deductible in the year they are paid if certain conditions are met. However, tax laws can change, and individual circumstances may vary, so it's advisable to consult with a tax professional for specific guidance on mortgage interest deductions based on your situation.

Q: Is buying down the interest rate only applicable to mortgages?

While buying down the interest rate is commonly associated with mortgage loans, it may be applicable to other types of loans as well, such as auto loans or personal loans. However, the availability and terms of buying down the interest rate can differ depending on the type of loan and the lender's policies. It's best to inquire with the lender or financial institution offering the loan to determine if this option is available.