The mortgage interest rate is often the most discussed factor on a mortgage. Everyone wants the lowest rate available. What happens if the rate a lender quotes you isn’t low enough for your liking? Are you stuck with it?
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Luckily, you can ‘buy’ a lower rate. You literally pay the lender for a lower rate. Just how does it work? We’ll show you below.
What is a Rate Quote?
When you apply for a mortgage and get a pre-approval, the lender will quote you a rate. Along with the rate, they will provide you with a list of many fees. Before you get overwhelmed looking at the sheet, understand that these fees are standard. They help the lender process and close your loan. However, every lender charges different fees.
As you compare fees from several lenders, you’ll want to look at several things:
- The interest rate quoted
- The fees charged
- The annual percentage rate (APR)
The APR gives you an idea of what the loan will cost you over its entirety. It will be slightly higher than the mortgage rate quoted. As a general rule, if the APR is about 1/8th higher than the rate, your closing costs are standard. If the APR is more than an 1/8th higher than the rate, you are paying higher than average fees.
One reason for higher than average fees is a buy down fee in order to secure a lower interest rate. Another word lenders often use is discount points. You pay points to discount your rate.
How to Buy a Lower Rate
Once you have the quotes from several lenders you can inquire about what it would cost to buy a lower rate. In other words, how many points would you have to pay to get the lower rate? Generally, lenders charge 1 point for every 0.25 drop in the interest rate. Of course, this varies by lender. You’ll only know what lenders will offer by asking them.
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The point is 1% of the loan amount. If the lender charges you 2 points, you’d pay 2 points. For example, if your loan amount is $200,000, 1 point would cost $2,000 and 2 points would cost $4,000. You pay these fees at the closing. Luckily, you may be able to write the fees off on your taxes, though.
Should You Buy A Lower Interest rate?
The real question is whether or not you should buy a lower interest rate. It comes down to more than whether or not you have the money. It’s whether it makes sense.
In order to determine this, you’ll need to know your break-even point. This is the point that paying the fee for a lower rate pays off.
In order to determine it, figure out how much the lower interest rate saves you each month. Let’s say it saves you $50 per month. Next, figure out how much the discount will cost. Let’s say it costs $2,000. You’d then do the following calculation:
$2,000/$50 = 40 months
It would take a little over 3 years to start reaping the savings of the lower interest rate. Now, the question is, will you be in the home that long? If you don’t see yourself staying in the home for at least 4 years, paying for a lower rate won’t make sense. Paying the higher interest rate for the short time you are in the home will make the most sense.
If you plan to stay in the home for the long term, you’d start reaping the savings at the 3 year and 4 month mark.
Should You Shop Around?
Just because a lender gives you the option to buy a lower interest rate, doesn’t mean they are the right lender for you. There may be another lender that will give you that lower rate without paying any points. This could save you thousands of dollars, so it’s worth shopping around.
When you shop around and receive quotes from lenders, don’t be afraid to tell another lender the quote you received. Sometimes they will try to beat the quote, giving you even more savings on your loan.
If you decide to buy the interest rate down, make sure you know the break-even point. Just making sure it makes financial sense to pay extra for 1/8th of a point lower rate can help you make the right decision. 1 point can be a lot of money depending on your loan size. Make your decision carefully before paying for a lower rate.