By paying extra at the time of closing you may be able to reduce the interest rate on your loan ? or ?buy-down? your interest rate. The buydown can affect your interest rate temporarily or permanently with the use of discount points.
Borrowers pay interest payments in advance to reduce the interest rate of the loan for the first 2 or 3 years of the loan. One common type of temporary buydown is the ?3-2-1 buydown? which lowers the loan rate by 3% the first year, 2% the second year, and 1% the third year. The primary advantage of a temporary buydown is that the borrower may be able to qualify for a larger loan with the first year?s reduced rate, and if the borrower expects his or her income to increase, then the larger future payments may not be a problem.
Borrowers can pay for ?discount points? to reduce the interest rate for the life of the loan. A discount point is equivalent to 1% of the loan amount, for example, with a $100,000 loan, one discount point would cost $1000. It usually requires 4 to 6 discount points to lower the rate by a full percentage point. This can be an effective way to save you money, but it depends on how long it takes to recoup the cost of the discount points. To see if this will make ?cents? for you, consider the following example:
A $100,000, 30-year mortgage with 0 discount points will have a rate of 7.5% ? resulting in a monthly payment of $699.21. Or, the lender suggests you buy 2 discount points and the rate will be reduced half a percent to 7.0%. For this option, the cost of the discount points is $2000, and the monthly payment will be $665.30. This would save $33.91 each month. Divide the cost of the discount points by the savings each month and it shows that it will take 59 months to break even for the cost of the points. If you are keeping the property for 5 years or more, then this would be a good option.
Discount points and buydowns can be a great way to save money ? but do your homework to see that it makes money for you, not just your loan officer.
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