When you are in the process of purchasing a home, especially if you will be obtaining financing, there are several line item closing costs you may be responsible for as a buyer, such as lender fees, appraisal fee, credit report fee, notary fee, escrow fees, document prep fees, attorney fees, title insurance, transfer fees and etc.  These fees are collectively called closing costs.  There are also pre-paid items such as property taxes, interest, and homeowners insurance they you will pay at closing to setup your mortgage loan as the first payment is anywhere from 30-60 days after closing.  Sometimes all of the closing fees and pre-paid items are lumped in together and called closing costs but just keep in mind that the pre-paid items are not actual fees.

Then, there are optional closing costs that you can choose to pay if you want to obtain a lower interest rate for your mortgage loan.  Or, you can choose a higher interest rate and have the lender pay some or all of the other closing costs involved in your purchase transaction.  The additional costs to buy down the interest rate are called discount points and the lender credit to closing costs is referred to as either rebate pricing or lender credit for the rate chosen. 

Discounts points are simply additional closing cost you can pay at closing to directly “buy” down the interest rate to reduce your monthly Principal and Interest (P&I) payment.  Each discount point reflects 1% of your loan amount is closing costs.  So, if you have a $400,000 mortgage loan amount, 1 discount point equals $4000 (1% of  the $400,000 loan). 

Rebate pricing or lender credits for the rate is credited to you at closing when you choose an interest rate high enough that the lender is “paying” you to take that rate.  Rebates/lender credits are priced the same way where each 1 points represents a lender credit amount of 1% of your loan amount. 

Most mortgage lenders offer a wide range of interest rate options for a buyer to choose from varying from 1-2 discount points in cost for the rate to 0 points then sometimes as much as 1-2 points in rebate pricing/lender credits to your closing costs.  The most important thing to understand when determining which interest rate option is the best one for you to select is how long it will take you to recover the upfront cost to “buy” the rate lower in the monthly savings.  This will help you determine whether or not you will own the home (or keep the mortgage loan) long enough to fully take advantage of the lower payment. 

Here’s an example of the costs/credits for discount points at different interest rates and the resulting monthly principal and interest payments at those different rate options:

The difference in the monthly payment between each of the rate options is approximately $60 per month.  If you divide the cost difference between 4.75% and 4.5% of $5000 by that $60 per month in savings, it will take 83 months or almost 7 years to recover that upfront cost with the monthly savings.   That means you would want to fairly certain you will keep the loan at least 7 years to  have enough time in monthly savings to recover the initial cost for the 4.5% interest rate versus the 4.75% rate option.   

If you are contemplating choosing between 45% and 4.75%,  you divide the cost difference between of $4000 (rebate of $4000 at 5% versus $0 points at 4.75%) by that same $60per month in savings, it will take 67 months or just over 5.5 years to recover that upfront cost with the monthly savings.  As you can see from these two options, the recovery time is shorter because the costs are lower to go to 4.75% from 5% versus going to 4.5% from 4.75%.  This is fairly typical when home mortgage shopping as the costs between the rate options are not a set amount and vary based on overall market conditions.

One last calculation to make is the cost and payment difference between 5% and 4.5%.  The cost difference is $9000 ($5000 cost for 4.5% plus $4000 credit at 5%).  The monthly payment difference is $120, so if you divide the $9000 cost by $120 payment difference, you would recover the cost in approx 75 months or just over 6 years.

Based on the above scenario then, you would not want to buy down to 4.5% unless you can swing the extra cash and will hold the loan for AT LEAST 7 years so you’d have enough time with the monthly savings to recover that upfront cost.  If you will be short term in the property (less than 7 years), the 4.75% and 5% rates are better options for you to consider. Ultimately, everything is situational dependent based upon your needs and your current financial position.  Any good lender will explain all of the above to you in detail during the pre-approval process so you know what your options are and if paying points makes sense in your particular situation.