by Brian Brady
Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL
Discount fees (sometimes called “points”) are considered pre-paid interest. Points are generally tax-deductible and are used to lower a buyer’s mortgage rate. Most real estate agents have been taught that “points” are “padded profit” to a lender or loan originator and should be avoided at all costs. Jeff Belonger debunked that myth yesterday; I was surprised to see the misinformed opinions being offered by the real estate agents and mortgage originators.
Today’s low interest rate environment combined with low expectation of immediate home price appreciation offers a perfect opportunity for buyers to secure a low mortgage rate by employing a strategy of “buying the rate down” through a discount fee.
Let’s look at an example, from today’s rate sheet-$400,000 purchase price, $100,000 downpayment, for a 720 credit score borrower with adequate income documentation:
RATE DISCOUNT FEE NET BORROWER COST
5.00% 0 $0
4.75% 1% $3000
4.5% 1.5% $4,500
The proper way to perform this analysis is to determine the expected minimum hold time for the mortgage. Most real estate agents will agree that in this environment, transaction costs combined with low expected appreciation rates suggest that five years is the absolute minimum to hold the property. Buyers may elect to move (and rent) the property but few agents would be so bold as to suggest that the buyer could make a profit in less than the five year time frame.
It is my opinion that refinancing the mortgage loan will be difficult and unprofitable, during those same five years because:
- low price appreciation will limit buyers ability to “harvest home equity“
- interest rates are at a 35-year low.
- rapid inflation seems likely due to massive government borrowing and the Federal Reserve’s “printing money” policy of the past 8-12 months. Inflation leads to higher mortgage rates.
Five years will be our minimum hold time for the mortgage loan then. This amortization schedule helps us determines what the lowest total costs are over five years. Simply add the cumulative interest (at month 60) plus the discount fee to determine the total costs:
RATE CUM. INT. + DISCOUNT FEE = TOTAL COSTS
5.00% $72,114 $0 $72,114
4.75% $68,391 $3000 $71,391
4.50% $64,677 $4500 $69,177
You can perform a similar analysis for four years:
RATE CUM. INT. + DISCOUNT FEE = TOTAL COSTS
5.00% $58,192 $0 $58,192
4.75% $55,207 $3000 $58,207
4.50% $52,228 $4500 $56,728
Or even three years:
RATE CUM. INT. + DISCOUNT FEE = TOTAL COSTS
5.00% $44,007 $0 $44,007
4.75% $41,765 $3000 $44,765
4.50% $39,525 $4500 $44,025
As you can see, somewhere around year three, the 4.5% option starts really paying off in this scenario.We can conclude then that paying the 1.5% discount fee for a 4.5% rate is more profitable after three years and indisputably more profitable for the expected five year holding time of the mortgage loan.
Doug Quance says:
No doubt that the current environment is favorable to lock-down a low interest rate… especially since you never know when the fools in Washington will curb the mortgage interest deduction.
Based upon history, your prediction of higher interest rates is almost guaranteed.
March 31, 2009 — 10:15 pm
Dylan Darling says:
Buying down rates can be a smart idea, especially if you plan on living in the home for 5-10 years. It can save you a substantial amount of money. Some people prefer to pay extra on their principal instead. Not a bad way to go either, if you have the extra money monthly.
Higher interest rates are coming in the near future. Lock low today.
April 1, 2009 — 7:24 am
Susan Zanzonico says:
First-time home buyers or renters planning to settle in somewhere are definitely in a good position. I have also seen various formulas where the seller pays the points for the buyer and nets more $.
April 1, 2009 — 8:02 am
Jeff Brown says:
Possibly the real gold nugget in this post is the value of objective, professional analysis, the lack of which has no doubt cost countless people who knows how much money.
It’s a crime how often folks never fully realize the options on their menus.
April 1, 2009 — 9:57 am
Judy Orr says:
I personally bought down the rate on a current purchase. We plan to keep the property for at least 10 years, if not longer, and the math made perfect sense.
April 4, 2009 — 11:03 am
John Heckendorn says:
How does that analysis look if you factor in NPV of the up-front points cost?
April 6, 2009 — 11:20 am
Brian Brady says:
Good question, John. I suppose you could assign an investment return for the lost opportunity cost of the discount fee, and deduct that future value from the total costs (for the no point loan).
If you use anything less than the note rate, it should still be favorable to pay the discount fee.
April 6, 2009 — 1:36 pm