How to Get a Lower Interest Rate

If you can't afford the home you want because interest rates are too high, you can "buy" a lower interest rate. Say you want to borrow $150,000, and your lender offers you a fixed-rate loan at 6%. Unfortunately, that requires a bigger monthly payment than you can afford. What you need is a rate of 5%.

You can get the lower rate you want by paying something called "points." By paying three points, your lender will give you a 5% rate.

One point equals 1% of your loan. Note: One point does not equal one thousand dollars (a common misconception). Since you seek to borrow $150,000, one point equals $1,500 (1% of $150,000). Three points, then, is $4,500. Thus, for a one-time payment of $4,500 in this example, you can "buy" your rate down to 5% from 6%.

Does it make sense to pay points? It depends — in this case on:

  • the spread between the no-point rate and the rate with points;
  • how long you plan to keep the loan;
  • whether you're dealing with a fixed-rate or adjustable-rate loan; and
  • whether you have the cash to pay the points.

Which is better: the 6% loan with no points or the 5% loan with three points? A 6% loan would cost you $899 per month vs. $805 for the 5% loan. Thus, paying three points lowers your mortgage payment by $94 per month. Since the points cost you $4,500, it will take you four years to recover that cost — not to mention the fact that by spending $4,500 on those points, you gave up the ability to earn interest on that money. That aside, if you keep your home (and your loan) for at least four years, you'll break even.

Clearly, the longer you plan to stay in your home, the more sense it makes to pay the points in exchange for a lower interest rate. If you're planning to refinance or sell your home in just a few years, it would be foolish to pay points.

Many people miss this point: Research from Freddie Mac and Penn State's Smeal College of Business found that only 1.4% of borrowers hold their loans long enough to profit by paying points. However, every situation is different, and because interest rate programs constantly change, there is no simple answer or "rule of thumb." A good financial advisor or loan officer can help you determine whether paying points is best for your situation.

Originally published in The Truth About Money

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