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FHA rate buydowns versus paying points: What’s the difference?

by Gina Pogol
October 19th, 2010

If you spend much time reading about FHA mortgages, you come across two terms: “Buying down” your mortgage rate, and “2-1 buy-down.” They sound similar, but they are completely different concepts.

Buying down your mortgage rate

This simply means getting a lower interest rate by paying higher fees. For example, you might be able to get a 30-year mortgage with a 5% interest rate at no cost — no loan fees, no appraisal fees, no nothing. Or you might be offered 4.5% with standard fees. But what if you want 3.5%? You’d have to pay extra — that extra cost is in the form of what are called “discount points.” Each point is one percent of the loan amount, and gets you a discount on your mortgage rate. It might cost you several extra discount points to lower your mortgage rate by a full percent.

Should you pay extra to lower your mortgage interest rate?

It depends on how much it costs and how long you expect to keep the mortgage. An FHA mortgage calculator can help with this. For example, if you take out a $300,000 mortgage with no points at 4.75% and expect to keep you home for five years, does it make sense to pay points? A point costs you $3,000, and if it lowers your mortgage rate to 4.5%, the difference in your monthly payment is $45 ($1,565 – $1,520).  In five years, you would have saved $2,700. It doesn’t make sense to pay $3,000 to save $2,700. So what if you shop around for better FHA mortgage rates and find a better lender that will drop your rate to 4.25%  for that same $3,000? Your new monthly payment is $1,476, your monthly savings increases to $89, and your savings over five years increases to $5,340. It may then be worth buying your rate down.

The 2-1 buydown

Mortgage rate buydowns are a different story. The FHA 2-1 buydown gets you an interest rate that is lower than the going rate for the first couple of years. So if the market rate on a 30-year mortgage is 4.75%, your interest rate the first year would be 2.75%, the second year it would be 3.75%, and then it would be 4.75% from year three on out. But it’s not like the lender just gives you that sweet deal for nothing. Rate buydowns require that you pay the difference upfront.

Huh?

Yep. Here’s an example of how the cost of a buydown is calculated.

Example: Standard 30-year FHA loan

$100,000 loan amount

8% interest rate = $8,000 a year in interest.

With the 2/1 buy-down the transaction would be as follows:

$100,000 loan amount

1st. year = 6% Interest rate = $6,000 in interest, a savings of $2,000

2nd. year = 7% interest rate = $7,000 in interest, a savings of $1,000

So the lender would charge you $3,000 now for the privilege of saving $3,000 over the next two years.

This is slightly oversimplified because the calculations are a bit more complicated, but it’s pretty much how it works. So unless you can get your seller to pay for it, there is little advantage in the 2-1 buydown for you.

The difference between buying your rate down and a 2-1 buydown is that the 2-1 won’t ever save you more than you pay for it. Buying your rate down can potentially save you more than the cost of the points.

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This entry was posted on Tuesday, October 19th, 2010 at 1:38 pm and is filed under . You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.

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