Should You Pay Points to Buy Down Mortgage Interest Rate?

20 Replies

I am currently refinancing a rental property that I own. The new loan will have a $77,000 principal balance and a 15-year amortization and term. The loan officer presented me with the following interest rate options:

3.75% with 0 points

-or-

3.25% with 1.29 points

-or-

3.0% with 2.43 points

Here is how I go about deciding whether or not to pay points to buy down the rate:

First, I need to think about some assumptions. In this case I assume that I will own the property for at least 15 years, during which time I will not refinance this loan (3-4 percent is a pretty amazing rate - I think we'll all be wondering how it was possible in 10 years!).

Next, I calculate the actual dollar cost to “buy” each rate:

3.75%: 0 points = no cost

3.25% : 1.29 points = $77,000 x .0129 = $993.30

3.0%: 2.43 points = $77,000 x .0243 = $1,871.10

I then calculate the principal and interest payment for each interest rate:

3.75%: P&I = $559.96 / month

3.25%: P&I = $541.05 / month

3.0%: P&I = $531.75 / month

Finally, I take the total annual savings of each lower interest rate and compare it with the 0 point option to determine a “rate of return” on my initial investment, the dollar cost of the points required to buy down the rate.

3.25%: $18.91 / month savings = $226.92 annual savings

$226.92 annual savings / $993.30 points paid = 23% annualized rate of return

3.0%: $28.21 / month savings = $338.52 annual savings

$338.52 annual savings / $1,871.10 points paid = 18% annualized rate of return

To make my decision, I compare the available rates of return on the points paid to my “opportunity cost of capital” or the rate of return I think I could attain on other similar investments. Since buying down an interest rate is a guaranteed (zero risk) investment - unless I were to sell the property - my opportunity cost of capital is very low, say 2-3%.

So I chose to pay 1.29 points for the 3.25% rate because the 23% rate of return exceeds my opportunity cost of capital and is higher than the 18% return offered by the 3.0% rate option.

It should be noted that if I assume I might own the property for a shorter length of time or refinance in the near future, that would change the decision making process and introduce additional variables into the decision.

What say you, fellow BP members? What other factors do you take into account? How do you go about choosing whether or not to pay points to buy down a rate?

Regards,

Nate 

Makes sense.  A bean counter might look at the tax impact, but the answer probably wouldn't change.  Thanks for laying out the process of your analysis. Very helpful.

Uh, not sure why you need to be asking that question since you clearly understood the entire thing.   In fact, you could easily turn that into a blog post on how to decide to pay points or not. 

@Cal C.  

I guess it was partially a rhetorical question haha. It is in fact a blog post I wrote this weekend for our website.

I am hoping the topic will elicit feedback from other investors on how they go about making the decision. I am not so bold as to assume mine is the only way.

Regards,

Nate

Thanks for sharing the math; very informative!

Great post @Nate Garrett  

A vote for you and it's so easy a caveman could understand it. 

Edit: If you don't want to read a bunch of boring calculations and just want an easy way to determine the "rate of return" on points paid to buy down an interest rate, I found this calculator. If you want to get into the weeds, continue reading at your own risk.

@Doug McLeod  

You bring up an important point that I had not thought of. There are tax implications involved in this decision as well. 

I reviewed IRS Publication 527 and it appears that there are several ways in which the points can be amortized. For simplicity's sake, let's say that I amortize the points equally over the term of the loan.  

In my initial analysis I also failed to take into account that the interest and principal amounts paid in year 1 will be different. Let's revisit the calculations:

Tax Implications

Option 1: 3.75%, no points

1st Year Interest Paid - $2,820.93

Amortized Points Deduction - $0.00

Option 2: 3.25%, 1.29 points ($993.30)

1st Year Interest Paid - $2,442.52

Amortized Points Deduction - $993.30 / 15 = $66.22

Total Interest + Points Deduction = $2508.74

Difference (Option 1 - Option 2) in IRS Deductions = $312.19

Assuming one is in the 28% tax bracket, option 2 would result in the loss of $87.41 in tax savings.

Principal Balances

The principal balances would also be different at the end of year 1:

Option 1 (3.75%) Principal Balance : $73,101.41

Option 2 (3.25%) Principal Balance: $72,949.92

Difference: $151.49

Conclusion

Let's revisit the total advantage gained by buying down the rate:

$226.92 in P&I payment savings + $151.49 additional principal paid down - $87.41 lost tax benefit = $291.00 total advantage

The adjusted year 1 "rate of return" on the points paid would be:

$291.00 / $993.30 = 29%

Whew. I'm sure there's a spreadsheet out there that does all of these calculations. If not, there needs to be! Edit: see top of post, of course there is one!

If you're still reading, thanks for sticking with me. I realize that's a lot of effort only to discuss the rate of return on a measly $1000.00 investment!

@Nate Garrett  I would compare the interest portion of the payment of the three loans, as that delta is your true savings.  

Love your analysis. The only thing I would add is if it would prevent you from being able to complete a deal. At 77k not a big deal. On the other hand I have totally taken lower IRR because it allowed me to be able to do a second one.

Originally posted by @Nate Garrett :

To make my decision, I compare the available rates of return on the points paid to my “opportunity cost of capital” or the rate of return I think I could attain on other similar investments. Since buying down an interest rate is a guaranteed (zero risk) investment - unless I were to sell the property - my opportunity cost of capital is very low, say 2-3%.

I don't think you are looking at this correctly.

Your overall cost of capital is normally divided into two parts: cost of equity, and cost of debt. Your lender will tell you your cost of debt, and most investors will tell you that their cost of equity is something in the 10-20% range. That is to say, they would only be willing to pay cash for an investment if it offers that sort of return.

This is why investors usually finance properties -- it is better to buy it with 4% money than with 10% money.  A blend of equity and debt yields a lower cost of capital than equity alone.  If your cost of equity was really 2-3%, you would be very opposed to any sort of financing, because it would increase the overall cost of capital on the investment.

Your opportunity cost, as a separate concept, in the words of Warren Buffett is "what can be produced by your second best opportunity".  If you could apply that money towards a down payment on a property that earns you 10%, then your opportunity cost is 10%.  If your return on investment for the points exceeds 10%, then pay the points.  If not, pay the higher interest rate and use the money on the investment that pays you 10%.

The Mortgage Professor has a calculator for calculating this EXACTLY here:

Break-Even Period on Paying Points on Fixed-Rate Mortgages

There is no need to estimate it when it can be done exactly.  

Enjoy!

Note that there are hoards of articles on his site about points selections, etc. too.  The content generally needs to be adjusted for investors somewhat because your cost of equity should be at least in the low teens even if you're a bad real estate investor.  

@Roger Rouse  

Great point re: "Opportunity cost of capital". I agree that term should be reserved for the rate of return that could be generated by your second best opportunity. Buffett always has a way of making things easy to understand!

I guess I wanted to give some consideration to the fact that the "rate of return" generated by buying down an interest rate is a guaranteed, zero-risk investment, assuming you keep the mortgage. Maybe a better term would have been "risk-adjusted rate of return".

@Bryan Hancock  

Thanks for the point out on the mortgage calculator. I had linked to that as well in my second post, but if you didn't read it I don't blame you. I was really getting in the weeds. Also agree re: cost of equity.

I'm all about cash flow so I would be wondering why you would go with a 15 year fixed instead of a 30 yr fixed? You can always pay more, but you can never pay less.  :)

 If you take all closing costs (including the points to buy down the rate) and divide that by the amount of money you save every month (points vs. no points) you'll get a rough estimate as to how many months it will take to pay off the closing costs.  

@Jeff Trevarthen  

As I'm sure you know, right now there is a significant difference in rates on 15 and 30 year mortgages. I was quoted 3.75% for a 15 year or 4.625% for a 30 year with 0 points. 

For the $77,000 loan above, I would pay $23,793 in interest on the 15 year note or $65,518 on a 30 year note if paid on schedule, for a difference of $41,725. I would also have a free and clear asset 15 years earlier by taking the 15 year option.

If I understand you correctly, you are asking why I wouldn't take the 30 year mortgage and pay it on a 15 year schedule. Valid argument. The 30 year note would provide some safety margin if rents fall.

For me it comes down to the spread between the 30 and 15 year interest rate. If the spread was less significant, I might consider doing exactly what you suggested.

My personal reasons for investing are more wealth-driven than income-driven, so I am comfortable locking myself into the higher payment with the knowledge that I may have to "feed the alligator" if rents fall. 

I don't have all of my properties on 15 year mortgages. Actually, most of them are on 30 year mortgages. I guess in this case, the significantly lower rate on the 15 year was too good to pass up. 

I know this is an old thread, but I believe there's a critical flaw in the reasoning that should be pointed out.  The claim is that paying points gives you an annualized rate of return, and this return is used used to compare to other investments.  For example, one rate of return is calculated like this:

$226.92 annual savings / $993.30 points paid = 23% annualized rate of return

The problem with this is that in most investments the rate of return is assumed to be *on top of your principal*.  If I get 2% annually on a savings account, I have 1.02% of my original principal at the end of a year.  This is not the case with buying points.  If you pay $993 in points, that money -- your principal -- is gone.  You don't end the year with 1.23% of the money you put in.  You end the year with $226.92, which is -77% return on your $993.

The rate of return gets better the longer you hold on to it.  In year 5 it's positive, at 2.7%.  It peaks at year 12 at 8.8%, and then ticks down.

Having said that, there is even more that can go into to calculating the rate of return of points.  When you have a lower interest rate, you pay off more principal faster, which increases you return when you sell.  Or, if you carry the loan to term, you saved all the interested in addition to the lower payment.

Yes, thank you for sharing! When I'm advising clients, the big question is "how long do you plan on being in/holding on to the property?" If it's long term, or a forever home, then the "discount" that they pay for the rate should be justified because it is supposed to be still significantly less than what they would otherwise pay in interest over the long haul with a higher interest rate. So, if someone is going to sell the property in a few years then paying a huge fee for a rate obviously does not make financial sense. 

@Rich Doan

I'm analyzing this for a duplex I have under contract and I think there is some interesting logic to your argument as well as the author's. I think the answer comes down to how long you plan on holding the loan without refinancing/selling/etc because you will, in fact, lose the money you pay for points. I'm doing my analysis with the Rate calculator in Excel and you only realize the full "cash on cash" savings the author presents when you hold the loan to maturity:

My formula:

=Rate(months,monthly savings,cost of points,future value)*months in a year

1) Holding property for five years:

=Rate(60,18.91,-993.30,0)*12 = 5%

2) Holding the property for ten years:

=RATE(120,18.91,-993.3,0)*12 = 19.56%

3) Holding the property for thirty years: 

=RATE(360,18.91,-993.3,0)*12 = 22.82% (the author's original claim)

I view the "break even point" as the number of years you're willing to hold the property to earn your cost of capital on the points. The opportunity cost is the financial sensibility to transact before the break even date.

This post has been removed.

@Nate Garrett Yep, I do the same thing. Just look at it as an ROI calculation. Same goes for remodels for your rentals, paying down your mortgage, etc.

@Tom Croyle

I must confess that I don't understand your use of the rate formula.  (Ok, I don't completely understand the formula.)  But I think one valid way to use the formula is like this:

=rate(number of years, payment per period, initial cost, final value)

I'll just look at the starting value and the ending value.  I'll ignore the monthly savings and just calculate what we have at the end of the period.

I'll put the numbers in for 15 years.  The amount you have after 15 years is

18.91 * 15 years * 12 months = 3403.8.

That gives the following rate:

=rate(15, 0, -993.3, 3403.8) = 8.56%

I'm just looking at how much money we put in, how much money we get out, and then calculating the effective annual rate of the money we put in.

For this I assumed that the cash you save every month is just put under the mattress and making no return.  If the savings were put into an account that earned 2% annually, you would have 3965.67 after 15 years.

That gives you the following rate: 

=rate(15, 0, -993.3, 3965.37) = 9.67%

These would be good rates, but not close to the 18+% rates mentioned by the OP, as it does not appear to account for the total loss of the cost of points.

Let me know if you think I'm doing this incorrectly.

-Rich

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