Nationally, the average 30-year fixed-rate mortgage rate stood at 7.79% at the end of October. Since then, it’s dipped to a still-high 7.44% per Freddie Mac’s Primary Mortgage Market Survey. While that is a reprieve for homebuyers, rates are still stubbornly holding near 20-year highs.
For some perspective, that decline in mortgage rates translates to a monthly savings of only about $100 based on an average home price of $513,400 ($2,854 in principal and interest with 20% down vs. $2,956, ignoring property taxes and insurance), which, while not nothing, is hardly significant.
So, what’s a prospective homebuyer to do? Should you make a larger down payment, should you settle on a builder you don’t love that’s offering rate discounts, or should you buy mortgage points?
The $513,400 price above comes from the St. Louis Fed, and disregards geography and local markets, as well as whether the properties are financed with a mortgage or purchased in all-cash transactions (which now represent about a third of all transactions), but will represent the base case for our purposes.
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To avoid the added costs of Private Mortgage Insurance (PMI) you’ll need to start off with a 20% down payment (it doesn’t make much sense to buy mortgage points if you’ll be hit with an additional 0.5%-2.25% for PMI because you’re not putting 20% down).
Typically, PMI is a percentage of the total loan balance paid monthly (1% PMI on a $500,000 loan is $5,000, or about $417 a month) in addition to principal and interest payments, but it may be charged as an upfront cost depending on your lender.
PMI doesn’t add any equity to your home, it’s simply an added expense homebuyers pay for carrying a “riskier” loan (for the lender).
Now, PMI will drop off your loan once you reach a 78% loan-to-value (LTV) ratio, so it’s not a permanent expense, but it’s best avoided if possible.
Assuming a 20% down payment, let’s look in more detail at the cost-saving options above.
Builder Rate Buydowns
One advantage that buyers of newly built homes have over buyers of existing homes is the possibility that their builder may be offering rate buydowns, where the builder (which normally requires that you work with their preferred lender) pays to reduce rates for all or a portion of the life of the loan.
One- or two-year buydowns are the most common offers builders are making these days and would reduce your mortgage rate for the first year or two of the loan. If that reminds you of the adjustable-rate mortgage fiasco of the early aughts, it probably should.
A 1% buydown from your builder saves you about $275 each month but adds the risk that, when the buydown expires (if it does), your monthly mortgage payment will rise by that amount.
While not as common, a buydown for the life of the loan (where the builder basically buys mortgage points for you) removes that risk in the future and is generally better for buyers.
Even with a buydown for the life of the loan, it’ll be very builder-specific, in which case you’ll need to weigh it against the other important factors like home design and quality, amenities, proximity to work/school/health care, etc.
Buying a home you’re not happy with just because it becomes more affordable is a recipe for buyer’s remorse, so it probably shouldn’t be the deciding factor, but rate buydowns should be part of the consideration.
A Bigger Down Payment
Making a larger down payment instead of buying mortgage points does offer some advantages. For one thing, the bigger down payment becomes immediate equity in your home (subject to the movement of housing prices) while also saving you money every month. For our base case, a 20% down payment is $102,680 while a 23% down payment would be $118,082.
The extra 3% down drops your monthly principal and interest payment from $2,854 to $2,747 and drops your total cost of the loan (assuming you pay it off over the 30-year life of the loan) from $1,028,716 to $990,115, saving you $23,200 in interest.
One caveat, the average life of a mortgage in the U.S. is only about 7-8 years due to home sales and refinancing, so the amount you actually save in interest would not be fully realized unless you lived in the home for 30 years without refinancing.
Equity aside, if you’re just looking at cash availability, you’d recoup the extra $15,402 in additional down payment after about 12 years ($15,402 additional down payment/$107 monthly payment savings).
At the end of that 12-year period, you’d also have more equity in your home as your down payment plus principal paid would total $186,610 vs. $173,871 with a 20% down payment. So, in that scenario, you’ve recouped the upfront cost via monthly savings while also adding about $13,000 in equity (assuming the price of the home doesn’t change).
Certainly not a bad option.
Buying Mortgage Points
Part of the reason we opted to use an additional 3% down is that many lenders cap the amount you can buy down a mortgage rate at three quarter points, which makes it a similar (but not identical) up-front amount. A point reduces your mortgage rate by 0.25% at the cost of 1% of the total loan.
Buying three mortgage points would drop your 7.44% mortgage rate to 6.69% and would reduce your monthly principal and interest payment from $2,854 to $2,647, saving you about $200 per month for the duration of the loan (and reducing the total cost of the loan to $953,565).
The cost of those points would be $12,322 ($513,400 - $102,680 down payment = $410,720 x 3% = $12,322) and, using the cash availability calculus above, you’d recoup that in five years.
Buying points doesn’t add to your equity in the same way that a larger down payment does, but it nearly doubles the amount you save in monthly payments.
As far as equity is concerned, at the end of the same 12-year period, your combined down payment and principal paid would total $181,292. But, on top of that, you’d save another $17,388 in monthly payments from years five to 12 (the period between when you’d have recouped your up-front cost for points vs. recouping the up-front cost for the larger down payment).
In other words, if you’re planning on staying in the same home for a decade or more (without refinancing), buying points offers a bigger financial advantage than the larger down payment.
If, on the other hand, you anticipate refinancing relatively quickly, or even in the next few years, buying mortgage points may be an added up-front expense that you do not fully recoup.
That was pretty math-heavy, so the main takeaway is this: The longer you plan on being in a home without refinancing, the larger the advantage of buying mortgage points. Whereas, if you anticipate refinancing sooner rather than later, and have extra cash to commit, the value of a larger down payment isn’t hampered by a possible refi.
So, see what offers builders in your area are making, look for rate-buydown promotions from lenders (they’re out there), and if you want to get into the nitty-gritty of the math, this mortgage calculator from Bankrate.com is a good place to start.
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