"Help! I do not want to pay these interest rates."
Here are 3 ways to reduce your interest rate:
1) BUYDOWNS
A buydown is a mortgage where the buyer obtains a lower interest rate for at least the first few years of their loan. There are different types of buydowns.
Here's how they work:
3-2-1 BUYDOWN
In a 3-2-1 buydown, the buyer has lower payments for the first three years. For the first year the buyer's interest rate is reduced by 3% and then goes up by 1% annually until the full interest rate applies beginning on the fourth year of the loan. The buyer may refinance or sell the home at any time. The buyer, seller, or builder pays the lender for the subsidy at closing.
Buyers can qualify more easily with lower rates and enjoy lower payments for the first few years of the loan. This makes sense, especially for buyers who expect their incomes to rise or add a spouse's income in the next few years.
2-1 BUYDOWN
Similar to the 3-2-1 buydown the 2-1 buydown reduces the interest rate for the first 2 years. For the first year the buyer's interest rate is reduced by 2% and then goes up by 1% the following year until the full interest rate applies beginning on the third year of the loan. Again, the buyer may refinance or sell the home at any time and the buyer, seller, or builder pays the lender for the subsidy at closing.
Let's do the math on these types of buydowns:
The buyer is borrowing $250,000 with a 30-year fixed-rate loan at 6.75%. They can choose between a 2-1 buydown or a
3-2-1 buydown.
Here's what the loan breakdown would look like with a 2-1 buydown option:
- Year 1: $1,304 at 4.75% interest
- Year 2: $1,459 at 5.75% interest
- Year 3: $1,622 at full 6.75% interest
The buy-down fee for this loan would be $5,759.
Now, say you choose the 3-2-1 buy-down instead. Here's what your loan payments would look like:
- Year 1: $1,158 at 3.75% interest
- Year 2: $1,304 at 4.75% interest
- Year 3: $1,459 at 5.75% interest
- Year 4: $1,622 at full 6.75% interest
Meanwhile, the buy-down fee for this loan increases to $11,324.
*If a buyer is considering a buydown, they should look beyond the initial lower payment period to determine whether the costs involved in the near term are worth any interest savings they would potentially realize.
Not all types of loans or all types of homes can be purchased using a buydown. FHA and USDA loans have additional requirements, and you should monitor for pre-payment penalties.
2) PAYING DISCOUNT POINTS UPFRONT
What if a buyer wants to lock in a lower rate for a longer period or for the life of the loan?
A buyer may choose to pay the lender upfront (at closing) for discount points.
Discount points are prepaid interest that the borrower can purchase to lower their rate on subsequent monthly payments.
There is usually a one-time fee, paid upfront during either a normal purchase or later if the borrower refinances.
Each discount point costs 1% of the total loan amount (not the purchase price) and lowers the loan's interest rate by one-eighth to one-quarter of a percent.
Check with individual lenders about their rules and requirements.
Discount points do not have to be paid out of the buyer's pocket, though they can be. The buyer may ask the seller to pay for the discount points or ask the builder for new-construction purchases.
Discount points make sense if a buyer is going to keep the house for a long time, as buying discount points can lock in a low rate for the life of the loan.
3) ADJUSTABLE-RATE MORTGAGES
An adjustable-rate mortgage (ARM) has features of both fixed and adjustable mortgages. Using an ARM, the rate is fixed for the first five, seven or 10 years, and then the rest of the loan becomes adjustable, meaning it fluctuates depending on current interest rates. There are usually caps as to how much it can adjust during any period.
BONUS: DID YOU KNOW YOU CAN DEDUCT THE COST ON YOUR TAXES?
Did you know that if a buyer pays discount points, they can deduct that cost on their taxes? The IRS considers discount points to be prepaid mortgage interest, and as such, they are generally tax deductible over the life of the loan.
If buyers and the home purchase meet certain conditions, then discount points can be fully deductible for the year when they were paid. Always work with a CPA or an accountant to verify this information.
