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Buying down the rate

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THE SCENARIO I've recently been talking with a lender to refinance a property. They told me that they can lend me $97,500 for 30 years at 7.375%, fully amortizing. They also said that if I paid them $2,015, they could reduce the rate to 6.5%. This is a commonly-available feature when you're getting a new loan, and is called 'buying down the rate'. Many times, the bank will have a variety of options with different costs, and they often won't tell you about it unless you ask. But sometimes it can be worth it to do a rate buy-down. So I'm considering whether to just take the 'standard' refinance rate, or whether to pay the money to get the lower rate. My question is 'If I buy down the rate, what's my return on the $2,015 I have to spend in order to do so?'
THE SOLUTION This is a four-parter, but each of the parts is fairly straightforward. First, I need to find out how much I'd pay per month if I took the loan at the 7.375% rate. Second, I need to find out how much I'd pay per month if I bought the rate down to 6.5%. Third, I need to use these two numbers to figure out how much money I save each month if I buy down the rate. Fourth, I need to find out what my return on my $2,015 up-front cost (to buy down the rate) is. This may seem daunting, but if we take it one step at a time, we'll see that there's nothing tricky going on here. Let's get started. First things first, make sure the calculator is using 12 Payments per Year. Step 1: The 'normal' loan N: 360 I/YR: 7.375 PV: 97,500 PMT: (this is what I'm trying to find) FV: 0 Step 1 answer: -673.41. So if I took this loan, I'd pay $673.41 every month. Step 2: The 'buy-down' loan N: 360 I/YR: 6.5 PV: 97,500 PMT: (this is what I'm trying to find) FV: 0 Step 2 answer: -616.27. So if I bought down the rate, I'd pay $616.27 every month. Step 3: What's my monthly savings? If I pay $616.27 from the lower rate instead of $673.41 from the higher rate, I save $57.14 per month. Step 3 answer: If I buy down the rate, I save $57.14 each month. Step 4: The return on the buy-down cost N: 360 I/YR: (this is what I'm trying to find) PV: -2,015 (if I pay this much today...) PMT: 57.14 (... then I save this much each month) FV: 0

The answer to the question is 34.03%. So if I buy down the rate, I make a 34% return on the $2,015 I spend to do the buy-down.

As I mentioned at the top, when you go to get a loan, there are often a variety of different rates available to you, and those rates carry a variety of costs. Sometimes, you can take a higher rate and the bank will actually give you money to take the loan. It's very important to be able to figure out which buy-down (or buy-up) option makes the most sense, and now that we've been through the process, you should be able to analyze your own loan prospects next time you're talking to a bank. What do you think? Leave a comment below!