We are frequently asked to give our opinion on paying points to buy down the rate on a mortgage.

Many folks believe that a higher interest rate means that you’ll pay more interest over the life of the loan, and that “buying down” the interest rate (through the payment of non-refundable fees and discount points) you’ll pay less interest over the long term.

While this is true, many times it does NOT make practical sense. Here is an example:

On a loan of $300,000, for the sake of argument, let’s assume that your closing costs will be around $2,000. In today’s market, a well-qualified buyer could obtain a mortgage at about 6.25% for a 30 year fixed rate mortgage with no points or closing costs. However, the same well-qualified buyer might choose to “buy down” the rate to 6% by paying points and fees of about $3,300.

Does it make sense to do so? Most people have no idea how to figure this out. Let’s go through this together!

The principal and interest (P&I) payment on a $300,000 loan at 6.25% would be $1,847. If you roll the closing costs into the loan (rather than paying the $3,300 out of pocket), the loan amount would then become $303,300. At 6%, the P&I would be $1,818, or a savings of $29/month.

Here’s the million dollar question: Does it make sense to give up $3,300 in price appreciation in order to save $29 per month? Figuring this out is fairly easy. Divide your additional cost ($3,300) by the monthly savings ($29) and voila! It will take 113 months (or more than nine years) to recoup the loss of equity. Or, to put it plainly, if you pay off the loan before this time, you will have lost money.

Be careful of seemingly low interest rates without full and up-front disclosure of the hidden costs.