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As I mentioned two weeks ago, we are living in a weird world. Two plus years of me saying that sentence has made me realize, our state of chaos is now the status quo. Somewhere the ball will always drop and quickly make us all learn to exist in a new environment. With that said, here's another tip to deal with the volatile mortgage rates. If you missed the first tip, shoot me an email. I’ll forward the last newsletter your way!
Option #2 – Buy down your rate.
Buying down rates has always been an option. To be honest, it just made no sense to do it when interest rates were 3.5%. What does buying down a rate mean? How do you, as a buyer, pay your lender, to lower interest rate? Enter Mortgage Points.
Mortgage points are a fee you, as a borrower, pay your lender to lower your interest rate. Strap in, everyone. There’s quite a bit of math coming your way. Grab wine if needed.
1 point = 1 percent of the loan amount AND usually lowers your rate by 0.25% Let’s say you’re borrowing $300,000 from the bank. 1 point = $3,000
Your lender quoted an interest rate at 6.5%. If you pay 2 points ($6000),your new rate would be 6%.
Everyone still with me? Take a sip of your wine, tea, water, whatever you need to keep you in the game. We got your rate lowered, BUT it’s more complicated. It’s important to think about if spending the 6k is worth it.
As you know, when you pay your monthly mortgage payment, a portion goes towards your principle (your equity, aka, money you get back) and a portion goes towards interest (money you pay the bank for giving you a loan). These two portions are not split evenly. Early on in your loan’s life, the majority of your monthly payment goes towards interest. Assume in the first year of your loan, the interest portion is 99% of your monthly payment, and only1% goes towards your principle. By year two you maybe at 97% going towards interest and 3% towards principle, and so on.
So, is it worth the $6,000 upfront to have a lower rate by 0.5%?
To determine this, you need to calculate how long, in YEARS, it would take to pay that same $6000 in interest if your rate was the original 6.5%. The formula is as follows:
$6,000 (your potential “points” payment) / $300,000(loan amount) = 0.02 or 2%
Buying 2 “points”= 0.5% of an interest rate savings = 0.005 (remember1%=.01, so 0.5%=0.005) Then we divide these numbers: 0.02/0.005 = 4 YEARS If you plan to hold onto the property you’re buying, for more than 4 years, buying down your rate makes sense. After 4 years, you are saving $$ by having a lower rate.
NOTE: If you have a magic crystal ball and can guarantee rates will go down in 2 years, don’t do this. In 2 years you can refinance to the rate of the time and be paying a completely different monthly payment. BUT I don’t have a crystal ball….