When it comes to getting a mortgage, you can choose the interest rate that works best for you, within a certain range. This is news to a lot of buyers who tend to believe rates are rigidly fixed.
The truth is you can vary the interest rate based on the amount you’re willing to pay in closing costs. The trick is to know when it’s to your benefit to pay a little more upfront to lower your monthly mortgage payment over the long run.
It is my job to educate clients on the cost vs savings and when a buyer will achieve the ‘Break Even Point,’ or what I call the ‘make sense point.’ If a buyer spends extra money to lower their rate they need to understand at what point they begin to see the financial benefit. To allow us to compare apples to apples, we will use a January 4, 2017 interest rate sheet. This sheet provides rates on a 30 year fixed loan with a 760 buyer credit score, and assumes a minimum 20% cash down payment.
Electronic rate sheets allow a loan officer to price various mortgage scenarios. Each rate sheet is specific to each kind of loan, accounting for every layer of risk such as property type, credit score, and loan to value. In hard copy form, there would be hundreds of rate sheets accounting for different sets of variables. Digitizing the calculations has enormously improved efficiencies.
Every mortgage company prepares their own rate sheets based on data they monitor. Lenders take into account information from Fannie Mae and Freddie Mac, which reflects investor appetite for mortgage bonds in the secondary market. They also watch the bond market, since mortgage rates are also closely tied to the 10 Year Treasury Bond. As bond prices go up, interest rates go down and vice versa. Rates often change throughout the day as market conditions change, similar to the stock market, and typically move in increments of 1/8th of a point (.125%). Interest rates are also impacted by the broader economy--when the economy is strong, rates generally move higher.
Mortgage rate lock: A guarantee that a lender will deliver a specific interest rate if a mortgage closes by a specified date. A rate lock protects the borrower should interest rates increase during the lock period.
On the rate sheet above, the far left column indicates the range of interest rates available for a loan meeting the specifications of our example (760 credit score, 30 yr fixed, minimum 20% down). The next column, P & I (Principal and Interest), shows the monthly mortgage payment, although mortgage insurance (if required) and property taxes are not included.
Each column after the first two reflect pricing for different rate lock periods: 15, 30, 45 or 60 days. The rate lock period reflects the number of days the mortgage bank agrees to guarantee a specific interest rate. If a buyer locks their rate as soon as their offer is accepted by a seller, they typically want the lock period to cover the time needed to complete home inspections, title search, appraisal, underwriting, document review, signing and closing the loan. It is possible to wait and lock a rate later in the transaction—for instance the buyer may believe that rates will drop before closing and choose to wait before locking in their rate.
Choosing a rate lock period requires taking local market conditions into account. For instance, in the Portland area, appraisals are currently taking additional days to complete, and many inspection periods are requiring extensions. With that in mind, most of my clients who lock their rate at the beginning of their transaction are choosing the 45 day term.
Notice all 4 right-hand columns are filled with numbers clustered around 100.00. On a rate sheet, the number 100 represents the Par Rate. At par, the borrower will not pay additional points or a yield spread to get a mortgage at that rate. The par rate generally represents the way to pay the lowest amount in closing costs.
The Par Rate is the interest rate at which the borrower doesn't have to pay anything (discount points) to obtain it. The par rate falls directly on zero (or 100.00 as seen in the rate sheet).
When I quote interest rates, I typically choose the rate from the 45 day column and read down the column to find the interest rate closest to 100.00, or the par rate. Referencing the rate sheet above, the rate closest to par would be 4.375%. At that rate, the borrower will pay the lowest amount of closing costs. Any interest rate below 4.375% would cost a discount fee to buy the rate down.
One final note: notice that the interest rates are closer to par when the rate lock is shorter term. If a buyer feels rates are going to remain stable, they may take a chance and hold off locking their interest rate until they are closer to finalizing the mortgage to take advantage of a slightly lower rate. Some mortgage brokerages also offer a one time “float down,” meaning if a borrower locks their rate and interest rates fall, they are allowed a one-time opportunity to adjust their rate lower before closing.
When and Why to Buydown an Interest Rate:
As an example of how the process works and how to assess the benefits of buying down an interest rate, we’ll walk through an example:
Joe and Faith need a loan to purchase their forever home—the home in which they intend to live for many years. They have plenty of assets for their down payment and closing costs. Their goal is to have the lowest possible monthly payment, looking ahead to retirement years when their income will be fixed. Joe and Faith are purchasing a home for $600,000 but they only wanted to borrow $250,000. They are choosing a high down payment even though mortgage rates are still very low as another way to reduce their overhead in view of their approaching retirement.
A mortgage buydown is an option to obtain a mortgage rate lower than the prevailing mortgage rate.
A buydown involves paying an up-front charge to obtain the lower rate. The process is often referred to as buying down the interest rate.
Joe and Faith could purchase their home by securing a loan at the par interest rate of 4.375% without paying extra fees. Their mortgage would be $1248 per month. But this couple, given their resources and desire to lower their payment may see the advantage of investing in a lower interest rate.
For example, Joe and Faith can lower their interest rate to 4.125% by paying a buydown fee equal to about 1% (or 1 point) of their $250,000 loan. The pricing of the buydown, or discount points, is determined by the bank at the time the buyer chooses to lock their interest rate. The price is always expressed as a percentage of the buyer's total loan amount.
Checking the rate sheet, it indicates that the lower rate (4.125%) with a 45 day lock is below par at 98.875. So the price Joe and Faith will need pay upfront to lower their interest rate is 1.125% of their loan--the difference between par, or 100, and 98.875. By multiplying $250,000 x 1.125%, I arrive at the buydown price of $2,812.50. Paying this fee will reduce their mortgage payment to $1211.62, a savings of $36.38 per month.
Total Interest Paid over the Life of Mortgage:
There is one other cost comparison to consider, and that’s the amount of interest a borrower pays over the life of a loan. For Joe and Faith, if they accept the higher interest rate of 4.375% and take 30 years to pay off the loan, they will pay $199,356.73 in interest. By paying the buydown of $2,812.50 to lower their interest rate to 4.125%, the total interest they will pay over the life of the loan is $186,184.76, a savings of $13,171.97.
To determine how much interest you will pay over the life of a loan, use an online mortgage calculator. Here is a link that will amortize the total interest paid on a mortgage, found on the Premier Mortgage Resources website:
For a couple like Joe and Faith, ready to settle on a home for the long-term, I would suggest an interest rate closer to 3.875%. They would need to pay a 2.750% discount fee of $6,875.00 ($250,000 x 2.750%, because the buydown is 97.250, or 2.750 points below par). Their monthly payment would be $1175.59 and total interest paid over the term of the loan $173,213.38—a savings of nearly $26,143.35 compared to paying the par interest rate of 4.375% (assuming they do not make additional payments).
To decrease the total amount of interest paid, they are in a good position to pay their mortgage bi-weekly rather than once a month. Paying 'bi-weekly' means one half of the monthly mortgage is paid in each pay period. By doing this, the borrower pays 26 payments each year, equal to 13 annual payments. Paying one extra payment a year pays down the loan much faster.
If Joe and Faith go ahead with the 3.875% interest rate and make bi-weekly mortgage payments, the total interest paid over the life of the loan will be reduced from $173,213.38 to $147,353.25, a savings of $25,860.13. In addition, the loan will be paid off in 26 years rather than 30 years.
To determine your savings from switching to bi-weekly payments, try this mortgage calculator:
When Does a Rate Buydown Begin to Pay Off?
The Breakeven Point is the point during the term of the loan where you begin saving money. For Joe and Faith, they are considering two options: a buydown fee of $6,875.00 to secure an interest rate of 3.875%, with a monthly payment of $1,175.59. Or they could pay a $2,812.50 buydown fee for an interest rate of 4.125% and a monthly mortgage payment of $1,211.62. The difference between the buydown costs is $4,062.50 and the difference between the monthly payments is $36.03.
To determine when Joe and Faith would reach the breakeven point and begin to see the benefits of paying the higher buydown costs, I divide the difference of $4,062.50 by the monthly payment savings of $36.03. In 112.75 months, or 9.40 years, they would then begin saving money. But until that point, they would not realize a benefit due to the upfront discount fee they paid for the lower interest rate.
Borrowers have access to interest rates above, below and between the examples I am using here. For Joe and Faith, who intend to live in their new home for the remainder of their lives, an interest rate buybown makes sense. But every borrower has to determine what makes sense for them, depending on their individual circumstances.
How to Determine What Interest Rate is Best for You:
- Consult with a CPA to discuss your interest deductions on the proposed mortgage. When comparing only interest savings and fees, you must also factor in total tax deductions in order to make the best decision.
- Ask your financial advisor what it will cost to make additional funds available if you want to buydown your rate. In what type of account are those funds currently held? How much interest are the funds earning? What is the penalty for withdrawing funds? Will you be required to pay taxes on the amount withdrawn? Liquidating funds may or may not work to your financial advantage. An advisor will help you understand the costs/benefits that apply to you.
- Even, or especially, if your primary goal is to have as little debt as possible, it is important to be clear that it can cost more over the long run than you suspect in fees, penalties and taxes to access funds. In the end, it may feel good to have a lower mortgage payment but the choice may actually decrease your net worth.
- Consider making a bi-weekly mortgage payment. It will reduce the total amount of interest paid, and reduce the years it takes to pay off a mortgage.
- Work with a loan officer you trust and ask questions. Interest rates are still very low by historical standards, but rates may rise in 2017 and every borrower should know their options.
If I can be of further assistance in choosing a mortgage, or understanding how much you are qualified to borrow, please call or email me. I'm happy to help.