Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Dr. Don,
My question is about home mortgages and the best way to go over a 30-year fixed-rate payment schedule. Should I buy down the interest rate or use that money to reduce the size of the loan?

Here are the facts:

• Initial loan = \$275,000.
• 6.85 percent for a 30-year fixed rate mortgage
• Cost to buy down rate half a point is \$4,125.

Would it be best to:
1) Buy down the loan and get the 6.35 percent rate for 30 years.
2) Keep the 6.85 percent rate for 30 years and use the \$4,125 as an additional principal payment with my first loan payment.

I do not know how to decide between the two options. Please advise and supply the calculations, so I can follow your analysis.
Tom Threshold

Dear Tom,
Key to the analysis is how long you plan to stay in the house. The longer you stay in the house, the longer you gain the benefit from paying down the rate.

But paying down the rate also reduces the probability that it will make economic sense to refinance the home at a later date. It also makes sense, at least for the purpose of the analysis, to reduce the loan amount at closing rather than making an additional principal payment with the first payment. If you make an additional principal payment you are shortening the loan term, which gives the two mortgages different payoff dates.

If you don't think you'll be in the house for 65 months, then you won't earn back the money you spent on buying down the rate. You also need to consider the cost savings after that point and the lost interest deduction on your taxes associated with the higher interest loan. The table below includes those items over the life of the loan.

 Comparing the alternatives of buying down or paying down your loan Buy down Pay down Buy down the rate (\$4,125) - Pay down the loan - (\$4,125) Loan amount \$275,000 \$275,000 Interest rate 6.35% 6.85% Loan payment (\$1,711) (\$1,775) Total payments (\$616,014) (\$638,975) Total interest expense (\$341,014) (\$368,100) 30-years 10-years Future value of \$63.78 payment differential @ 8% interest \$95,689 \$11,746 Future value of reduced interest deduction @ 8%, 36% tax rate (\$27,168) (\$2,597) Advantage to buying down the interest rate: \$68,521 \$9,149

Buying down the interest rate saves you \$63.78/month on your monthly payment. Investing that money at 8 percent gives you an investment portfolio totaling \$95,689 at the end of the mortgage.

The lower interest rate reduces the interest expense. That's a good thing, but it also reduces the interest expense deduction on your income taxes. The loss of that tax deduction over the life of the mortgage, assuming the tax savings were invested at an 8 percent return, 30 years from now it represents \$28,862. (Not everyone is able to use the interest expense deduction. If you can't, then don't consider the lost deduction when deciding whether to buy down the interest rate.)

The points paid to buy down your interest rate may be deductible in the tax year that they are paid. Check with your tax adviser. This analysis assumes that the prepaid interest expense is deductible in the year that it is paid.

The typical mortgage is held for between seven and 12 years. Assuming that you will stay in the mortgage for 30 years when deciding whether to pay down the interest rate isn't all that realistic for the average homeowner, but even if you were only in the mortgage for 10 years, the analysis would still point toward buying down the interest rate.

Establishing credit

Dr. Don,
My company transferred me from the United Kingdom to the United States about one-and-a-half years ago. During this time, I applied for and received an American Express card and purchased a car.

However, I was recently declined an overdraft facility with my bank due to insufficient credit history and several credit inquiries. I would like to apply for a Visa credit card to help establish credit. How should I do this, and which card is best? There are just so many.
Julie Sheffield

Dear Julie,
Expatriates living in the United States have to start from scratch when establishing credit here. You've taken some good first steps in establishing credit, and you're right to think that establishing a payment history with a national credit card will help improve your credit history. (This Bankrate feature chronicles some of the problems people have establishing credit when moving to the United States.)

The credit inquiries that count against you on your credit report are the instances where you've applied for credit. Don't flounder about applying to multiple credit card companies because it makes you look desperate for credit. Lenders don't like to lend to desperate people.

Limit your applications to one or two cards. Bankrate has a credit card search feature that lets you decide what's important to you in a credit card and will provide you a list of the card companies that offer credit cards that match your priorities.

If you've been denied credit in the past 30 days, ask the lender which credit reporting agency provided them with your credit report because you are entitled to request a free copy of your credit report from that CRA. The cost of credit reports varies from state to state, but shouldn't cost more than \$9 for a copy.

-- Posted: June 29, 2001

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