Understanding The Mortgage Buydown

Buying a house is an undeniably expensive task. Even when interest rates are seemingly low, there is still the cost of borrowing money – but this doesn’t mean that there isn’t anything you can do to ensure your mortgage payment is more manageable.

With a mortgage buydown, you have the opportunity to pay more upfront in order to receive a lower interest rate on your mortgage. To learn more about what buydowns are and if they might be right for you, continue reading.

What Is a Buydown on A Mortgage?

A buydown could be a great way to save on your mortgage payments. It involves paying discount points at closing, which act as prepaid interest that lowers the loan’s interest rate. 

Alternatively, if you can arrange it with the seller, they may pay a portion of the points needed to reduce your interest rate for an initial period. This allows you to make monthly payments more affordable during that period and protect yourself against any sudden increases in mortgage rates. Whether it’s a conventional, FHA, VA, or USDA loan – a mortgage buydown can be used to suit your needs.

Taking into account the current market prediction of rising rates, this option may be worth looking into if you want to save money over the long haul.

How Much Does It Cost to Buy Down an Interest Rate?

The cost of buydowns varies, but typically you’ll need to pay points upfront. These points are a one-time fee that reduces the interest rate of your loan. 

Generally, each point you purchase will equal 1% of the loan amount and lower the rate by 0.25%. For instance, if your loan amount is $600,000 and the interest rate is 6%, paying one point, equivalent to $600,000 * 1% = $6000 can bring it down to 5.75%.

Who Can Buy Down a Mortgage?

Buyers can benefit from a buydown, but they don’t have to be the ones who foot the bill. Sellers and builders often purchase points that reduce the buyer’s interest rate, helping them save money on their mortgage payments in the long run.

Buyers

Buyers pay a certain number of points upfront in exchange for a lower interest rate. This can help reduce payments for years or the full loan term, depending on the mortgage buydown structure.

Sellers

To encourage buyers to purchase their home, sellers may offer a buydown of the buyer’s mortgage as a way to sweeten the deal. This one-time payment can be made into an escrow account or allocated over the entire loan term within seller concessions. 

The funds from this subsidy enable lenders to reduce the buyer’s interest rate, making it more affordable for the buyers to pay for their home loan. However, this expense is usually recouped by increasing the sale price of the home with the cost of the subsidy.

Builders

To attract early buyers to their newly constructed communities, builders may make up-front payments to buy down buyers’ mortgages. These payments are often used as an incentive. Once the community has been established, however, the builder is unlikely to offer this kind of concession. Builders may also offer incentives for mortgage buydown on existing home inventory too.

How Buydowns Are Structured

There are two types of buy-downs available: temporary and permanent. A temporary buydown lowers the mortgage rate for a specific period, typically 1-3 years, before reverting to the market rate. Meanwhile, a permanent buydown is just that; it will stay in place for the life of the loan. 

Temporary Buydown

The three most common temporary mortgage buydown arrangements are the 3-2-1, 2-1, and 1-0 buydowns. Here’s a quick overview of each:

3-2-1 Buydown

With a 3-2-1 buydown, a borrower can enjoy lower interest rates for the first three years of their loan. 

For example, if you qualify for a 30-year mortgage at an interest rate of 6%, opting for a 3-2-1 buydown will reduce payments as follows: 3% in year one, 4% in year two, and 5% in year three. After this period has lapsed, the interest rate will stay at 6% in years 4-30 until you decide to sell or refinance.

Taking the same example of a $600,000 30-year loan with a 6% interest rate, we can observe how a 3-2-1 mortgage buydown affects the buyer’s monthly mortgage payment.

Mortgage points charged for the buydown can vary from lender to lender, but you will often find that the cost of a buydown is generally about the same amount as what the buyer will save in interest. 

Taking our example above, the mortgage buydown cost around $26,112, which amounts to roughly the same amount as what was saved in interest over 30 years.

2-1 Buydown

A 2-1 buydown is a similar structure to the 3-2-1, with the difference being that the discounted rate only applies during the first two years of the loan term. In our example of a $600,000 30-year loan with a standard interest rate of 6%, this would give the buyer an interest rate that is reduced by 2% in the first year and 1% in the second year. 

Let’s look at how this affects their monthly mortgage payment.

The buyer can expect to pay around the same as the interest saved over the first two years of their loan term – approximately $13,308.

1-0 Buydown

A 1-0 buydown can provide a 1% reduction in the interest rate of a loan over the initial year. This structure can be seen clearly in the chart below, which illustrates what this could look like for a $600,000, 30-year loan.

Permanent Buydown

If a buyer seeks to reduce their interest rate for the entire duration of their loan, they can purchase more points upfront in exchange for a higher cost. This will ensure that both the interest rate and mortgage payments remain unchanged.

The total amount required to buy down the mortgage may be larger than those who only opt to buy down the mortgage for two or three years. For instance, a buyer may decide to buydown their $600,000 loan’s interest rate to 5% for all 30 years; this would result in monthly payments of $3,221 and a savings of $4,512 every year as well as $135,360 throughout the 30 years.

By taking advantage of a monthly mortgage calculator, buyers can get an estimated monthly payment based on varying interest rates.

Pros and Cons

When considering whether to go for a buydown when purchasing a home, various key factors must be taken into account. 

These include the size of the mortgage, your initial interest rate, the savings you can make, and your expected future income. Additionally, how long you anticipate being in the property can also influence your potential break-even point.

Should You Buy Down Your Mortgage Rate?

Buydowns can be more beneficial when the seller or builder offers to pay the discount points on behalf of the buyer without significantly inflating the purchase price of their home. When a buyer intends to pay for these points themselves, certain circumstances must be taken into consideration. Having adequate savings to cover down payment and closing costs plus a significant amount of leftover cash is a good indicator that buydowns may be suitable for them.

Buydowns may make sense for those expecting an increase in salary in the future; such as a graduate student about to receive their degree, or a stay-at-home parent returning to work shortly after obtaining a loan. However, keep in mind that buydowns involve paying more money upfront, so they only really make sense if you plan on owning your property for an extended period.

The breakeven point is a simple calculation that shows how much money you need to save to make the mortgage buydown worth your while. It varies depending on the loan term, interest rate, and loan amount. 

To calculate it:  Breakeven point = (cost of mortgage buydown) / (monthly savings)

Let’s consider an example of how a mortgage buydown works. If you were looking to take out a $600,000 loan over 30 years with an interest rate of 6% and had the option to pay four discount points to reduce your rate by 1%, you would first need to calculate the cost of the buydown. As each point costs around 1% of the total purchase price, in this case, you would pay $24,000. So, the cost of your mortgage buydown is $24,000.

By taking out this mortgage buydown, you would find that your monthly payments decreased from $3,597 to $3,221 – a difference of $376 per month. 

To determine your breakeven point, simply divide the cost of the buydown ($24,000) by the monthly savings ($376). You’ll discover that it takes around 64 months or 5 years and 4 months for you to break even.

If a borrower decides to refinance their mortgage before the buydown period ends, they will not be able to recoup any of the costs associated with the buydown.  If you expect to sell or refinance the home before 64 months (if you’re the buyer from the previous example!), a buydown may not be the most cost-effective option for you. Consider increasing your payments to pay off your mortgage quicker instead and save on interest payments.

Are There Limits on Buydowns?

Before considering a mortgage buydown, it’s important to speak with a lender about any questions you may have. Generally speaking, these types of loans are only available for primary and secondary residences (during purchasing or refinancing) and require that borrowers qualify for the standard interest rate of the zero-point loan.

• When it comes to investment properties or refinances for cash out, mortgage buydowns are not an option. However, you may still be able to buy down on a refinance that isn’t government-backed.
• Generally speaking, adjustable-rate mortgages (ARMs) are only eligible for plans with an initial fixed-rate period of three years or more.
• To curb home prices from becoming too high, some states will cap the amount a seller can subsidize. Therefore, in certain locations, there may be limits on how many points a seller or builder can subsidize a buyer.
• When it comes to federally funded programs, such as FHA loans, there are certain restrictions. For instance, when purchasing a home, temporary buydowns are only allowed on fixed-rate mortgages; refinancing or obtaining an ARM mortgage does not qualify for a temporary buydown. However, permanent buydowns are allowed.

Conclusion

In general, mortgage buydowns allow buyers to reduce their monthly payments for a set amount of time or permanently. Through the payment of discount points at closing, borrowers can slightly reduce their interest rates, leading to potential long-term savings.

However, it is important to consider whether buydowns are appropriate for individual circumstances. If you are thinking about buying down your mortgage, it is advisable to calculate the breakeven point to judge whether the upfront cost will be worthwhile in the long run.