There’s a direct relationship between mortgage rates and fees, meaning that you can elect to pay higher fees for a lower rate. This is known as “buying your rate down” or “paying points.”
Let’s review these terms, and discuss how to understand loan quotes, and how to know when buying a rate down actually benefits you.
Rate quote basics
A mortgage rate quote is a combination of rates and fees. Initial quotes often come in online forms or emails, then the quote is eventually formalized into a federally-required form called a Loan Estimate once you’ve completed a full loan application.
Your loan quote will show you what kind of loan you’re getting (such as a fixed or ARM loan), what your rate is, and how much you’re paying for that rate.
The loan quote always must show annual percentage rate (APR), which is a calculation that helps you determine how much you’re paying for the rate. As a rule of thumb, if APR is about .125 percent higher than the quoted rate, the fees will be customary and normal. If APR is more than .125 percent higher than the quoted rate, the fees are higher than normal, and may include a rate buy down. In either case, you must ask to review a line-item breakdown of fees.
“Buying your rate down” or “paying points” both mean that you’re paying an extra fee to get a lower rate. This fee can be called origination fee or points on your loan quote. It’s based on a percentage of your loan amount, and it’s in addition to more traditional fees like appraisal, credit report, underwriting, and title insurance (more below on locating these fees in quotes).
You might get a quote that includes two options: one for points, and one for no points. For example, if you were getting a 30-year fixed loan of $300,000, the quote with no points might show the rate as 4.25 percent, and the quote with 1 percent in points might show the rate as 4 percent.
In this example, the points would be $3,000 because they’re equivalent to 1 percent of the loan amount. This $3,000 is in addition to all other traditional fees.
The $3,000 lowers your rate by .25 percent, which lowers your payment $44 per month, and lowers your interest cost $62.50 per month.
Check today’s mortgage rates on Zillow
Does buying down your rate make sense?
To determine whether buying down your rate (aka paying points) makes sense, you have to calculate how long it takes your monthly interest cost savings to repay the cost of the points.
In this example, $3,000 in points gives you monthly interest cost savings of $62.50. So we divide $3,000 by $62.50, which shows us that it takes 48 months — or four years — for the interest cost savings to repay the points.
If it takes four years to break even on paying points for a 30-year fixed loan, this provides many years after the breakeven period to benefit from the lower rate.
Conversely, if you had a four-year breakeven period on a 5-year ARM loan, then you’d only have one year of benefit from the lower rate before the loan adjusted.
This breakeven calculation is the key to determining whether buying down your rate makes sense.
Generally, paying 1 percent of the loan amount in points will lower your rate by .25 percent, but this isn’t always the case. Ask your lender to provide options for paying points (or buying your rate down) so you have a few options to analyze for favorable breakeven timelines.
Obtaining and reading loan quotes
The law defines a full loan application as having provided the following six items:
- Property address
- Home value estimate
- Loan amount
- Social Security number (used to obtain your credit scores)
Once you’ve submitted your full loan application, your lender has three days to give you a Loan Estimate document.
Page 2 of the Loan Estimate shows points in the top left section called Loan Costs. This will show the exact percentage of the loan amount for any points being quoted. It also shows the dollar amount of the points.
These are the figures you’d use to make your breakeven comparison calculations.
Page 2 of the Loan Estimate also shows all the other line-item fees you’ll pay for the loan, so you have a full picture of your transaction before you go forward.