Should You Pay Points to Buy Down Mortgage Interest Rate?

[Nate Garrett]

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