Should I “buy down” the rate (pay discount points)?

Buying down the rate refers to the payment of discount points in exchange for a lower interest rate. A discount point is one percent of the loan. Hence paying two discount points on a $100,000 loan requires $2,000. There is a simple and more complex method of determining whether or not to buy down the rate.

The simple approach to the question of whether or not you should pay discount points requires a basic mathematical calculation. Divide the difference of the cost of discount points on two loans by the difference in the payment. If you'll be keeping the loan longer than the number of months indicated, the payment of the discount points is mathematically warranted.

For example, on a $100,000 loan, if your alternatives are taking an 8.375% rate at zero points, or an 8.125% rate at one point, this calculation tells you:

Rate Points Monthly Payment
8.375 0 $760.07
8.125 1 $742.50

By paying one point or $1,000 (.01 x $100,000 = $1,000) you will reduce your monthly payment by $17.58. Dividing the point cost by the monthly savings shows that it will take you 57 months to make up for paying the point ($1,000/17.58 = 57 months).

A more complex method involves variables such as the borrower's lost rate of return on money used for discount points and the risk/reward ratio of the buy-down.