With mortgage interest rates hovering around 6%, buying points is an effective strategy to make homeownership more affordable.
Mortgage “discount points” trade cash up front to reduce the interest rate and save money over time. Counterintuitively, paying cash to reduce interest rate may leave more cash in your pocket in the short term and long term. The long term is easy to understand because lower rates translate to a lower monthly payment. In the short term, putting 20% down on $500k home isn't easy. That's $100,000 not including closing costs. If you can only muster up 15% or $75,000, it's more efficient to buy down the rate with 2 discount points and only use 10% for a down payment. You could end up with a rate lower than the par rate (w/o any points) at 15% down and 3% more cash in hand.
Monthly benefits are realized in two ways: cash.First, the cash savings occur monthly with every payment being lower compared to the "un-discounted" rate. All other things being equal, lower interest rates mean lower payments. Secondly, mortgages are amortized and front-loaded with interest. A decrease in interest rates is also accompanied by an increase in the principal portion of your monthly payment.
Interest Savings = Cash + Equity
The total interest cost on a $500,000 loan at 6% over 30 years is $579,191. If the rate is reduced to 5% with the purchase of discount points, the total interest falls to $466,279. A savings of $112,912. Albeit, these savings are over 30Yrs. What about a more reasonable length of time e.g. 10yrs?
10 Year Interest Savings = $49,356
$49,356 = $37,637 Cash + $11,719 Equity
A discount point costs 1% of your loan amount but the discount in buys usually varies from 0.5% to 0.25%
Discount points vary by lender. A point is equal to 1% of the loan amount but the rate table determines the incremental value and can suggest how many to buy. As the buy-down becomes less favorable, say 3 for 1 or 4 for 1. The breakeven period gets longer. You also don’t have to buy the rate down 1%. In the table below, I calculate the incremental cost to buy down each eighth or 0.125% of the rate down. Keep buying 2-for-1s and 3-for-1s but never 8-for-1s and it's a toss-up whether 4-for-1s are worth it depending on how long you plan on staying. If you can buy 3 or 4 points to reduce the rate by 1%. The breakeven would increase to 4yrs and 5yrs 4months respectively.
Buying a home is a complex decision so most people stick to the conventional wisdom of 20% down, a 30-yr loan term. Rates of 6% will cost a pretty penny or 115.8% of your loan amount in interest over 30 years. Since most people don't have 20% down, the rate could be even higher and trigger private mortgage insurance (or PMI)