The U.S. housing market has been on a remarkable surge, with home sales reaching the highest level seen since 2006 in 2021, hitting a whopping 6.1 million transactions, up from 5.6 million in 2020. Whether you’re a prospective homebuyer looking to save money on your mortgage payments or a property seller trying to close a deal faster, there’s one powerful tool that you shouldn’t overlook – temporary buydowns.
This mortgage financing technique can help you lower your interest rate and save money in the first few years of your loan.
So, let’s dive in and explore this powerful tool that can potentially save you thousands of dollars.
What Is a Temporary Buydown?
A temporary buydown on a mortgage is an arrangement where the borrower pays a certain amount of money upfront to temporarily reduce the interest rate on their mortgage for a set period of time, usually the first one to three years of the loan term.
The money to fund the buydown can come from the borrower, the seller, or a third party. During the buydown period, the borrower makes reduced mortgage payments, which gradually increase until they reach the full, original interest rate.
How Temporary Buydown Works
If you choose a temporary interest rate buydown, the interest rate on your mortgage during the buydown period will be less than the final rate stated in your contract. Nonetheless, mortgage investors need to be confident that they will receive the full interest rate as agreed upon. So, how does this process work?
The difference between the interest amount calculated based on the full rate and the amount you’re actually paying during the buydown period is placed in an escrow account. This account may be funded by your lender, seller, or real estate agent involved in the transaction as mentioned before.
Let’s say you are purchasing a home for $300,000 and you’ve agreed on a 30-year fixed-rate mortgage with an interest rate of 6%. However, you want to lower your monthly payments for the first two years, so you negotiate a 2-1 temporary buydown arrangement with the seller.
Under the 2-1 buydown, your interest rate would be reduced by 2% in the first year and by 1% in the second year, before going back up to the full 6% rate for the remaining 28 years. This means that your interest rate in the first year would be 4%, and in the second year it would be 5%.
To compensate for the lower interest rate during the buydown period, the seller agrees to fund an escrow account with the difference between the amount owed at the full interest rate of 6% and the reduced amount owed during the buydown period.
For example, if your monthly payment at the full 6% interest rate would be $1,799, but your payment during the first year of the buydown period with the reduced 4% interest rate would be $1,432, then the seller would fund the escrow account with the difference of $367 per month for the first year.
Each month, the lender is reimbursed from the escrow account to compensate for the discrepancy between the sum you pay during the buydown term and the sum due based on your complete interest rate. This guarantees that the lender obtains the entire interest amount specified in the contract.
How Much Does It Cost to Do a Temporary Buydown?
Let’s talk about the cost of temporary buydowns. When you’re exploring your mortgage options, you may come across the opportunity to reduce your interest rate by paying the difference in interest upfront. The cost of the buydown ultimately depends on the total loan amount and the buydown schedule you choose.
To lower your interest rate during the buydown period, you’ll typically need to pay points (interest) upfront. These points are a one-time fee that can reduce your interest rate.
The cost of a buydown will vary based on the amount you borrower, the rate you receive and the buydown schedule you choose. The cost for the buydown will typically be expressed in actual dollars, but in some case, may be expressed in points. One point is equivalent to one percent of a borrower’s loan amount.
While paying points upfront may increase your upfront costs, it can save you money in the long run by reducing your interest payments over the life of the loan. So, it’s essential to weigh the upfront costs against the potential savings to determine if a temporary buydown is a right choice for you.
Who Can Benefit from a Temporary Buydown
When it comes to real estate, buying & selling can be a bit of a tricky game. But with a temporary buydown, everyone can come out as a winner. Whether you’re a home buyer looking for some breathing room in your budget or a seller trying to make your home stand out in a crowded market. A temporary buydown can be a game-changer.
For homebuyers, temporary buydown means a lower interest rate during the first few years of their mortgage. That means more money in their pockets each month and a little less stress on their bank accounts. And for sellers, offering a temporary buydown can be the extra nudge a buyer needs to choose their home over the competition.
So, whether you’re a buyer, seller, a temporary buydown can be a win-win for everyone involved.
Different Types of Temporary Buydowns and Their Calculations
Temporary mortgage buydowns can be an excellent option for homebuyers looking to save money and make mortgage payments more manageable during the early years of homeownership. However, to make an informed decision, buyers need to understand the calculation process for the three most common temporary buydown arrangements, 3-2-1 buydown, 2-1 buydown, and 1-0 buydown.
With a 2-1 buydown, for example, you can reduce your interest rate by two percentage points in the first year, then by one percentage point in the second year, before rising to the full rate after that.
In the meantime, a buydown plan that follows the 3-2-1 structure spans three years. It involves a decrease of three percentage points in the interest rate during the first year, followed by a reduction of two percentage points in the second year, and finally, a decrease of one percentage point in the third year
You can check this article to get a better understanding of how each arrangement works.
By understanding the details, buyers can accurately calculate their monthly payments during the buydown period and plan for their future mortgage payments. Additionally, a clear understanding of the intricacies of temporary buydowns will enable buyers to negotiate with sellers and lenders with confidence and make informed decisions that align with their financial goals.
Advantages and Disadvantages of Temporary Buydown
Let’s explore the pros and cons of temporary interest rate buydowns:
Pay Less Interest
With a temporary buydown, you can enjoy a lower interest rate, which is being paid from an escrow account by a seller, builder or even lender. This translates to savings on interest payments and more money remains in your pocket.
Lower Payment at the Start
With a temporary buydown, you’ll have a lower mortgage payment at the start of the loan, giving you some breathing room to make other investments in your new home.
Need for External Funding
The main downside of temporary buydowns is that someone else needs to fund it. In a seller’s market, your offer may be less competitive if there are other offers without such a buydown request. However, if the seller is motivated to sell, a buydown can be a good thing, and your real estate agent can help negotiate.
Buydowns only last for a certain period, after which you’ll have to make payments at the full interest rate. It’s essential to understand the terms of the buydown and ensure that you can handle the higher payments when the lower rate period ends.
Overall, temporary interest rate buydowns can be a useful tool for saving money on interest payments, but it’s important to consider the downsides before committing to one.
Other Risks Associated with Temporary Buydown
A temporary buydown may seem like a great option for lowering your mortgage payments and saving on interest, but it’s important to consider the potential risks. Here are some factors to keep in mind:
- Rates don’t improve: If interest rates don’t improve, you may not be able to refinance and take advantage of lower payments in the future.
- Home values decline: If the value of your home goes down, you may not be able to qualify for better terms, especially if you have a low down payment.
- Changes in credit: Any changes to your credit score or credit report can impact your ability to qualify for a new loan with better terms.
- Employment changes: Changes in employment, such as becoming an independent contractor or losing a job, can also affect your ability to qualify for a new loan.
It’s important to carefully consider these factors before choosing a temporary buydown option for your mortgage. Be sure to discuss your options with a trusted mortgage professional to make an informed decision.
In conclusion, a temporary buydown can be a useful tool for homebuyers looking to manage their mortgage payments during the early years of homeownership. However, it’s important to understand the costs involved and how the process works to make an informed decision. Working with a qualified mortgage professional can help you navigate the complexities of a buydown and ensure that it aligns with your financial goals.
Use my free mortgage calculator to help estimate your temporary mortgage buydown.
Temporary Buydown Mortgage FAQs
Is A Temporary Buydown A Good Idea?
A temporary buydown can be a good idea for homebuyers looking to save money and manage their mortgage payments during the early years of homeownership, but it depends on individual financial goals and circumstances.
How Long Can A Temporary Buydown Arrangement Last?
A buydown arrangement can last up to three years, depending on the terms of the agreement.
What Types of Loans Are Eligible?
You can opt for a temporary buydown option with all types of fixed-rate purchase loans. However, it’s important to check with your lender to see if they offer temporary buydowns and if there are any specific requirements or limitations for your particular loan type.
What Happens To The Funds If The Property Is Paid Off Or Sold Early?
If the mortgage is paid off entirely, foreclosed, or a short sale or deed in lieu is executed, any remaining funds must be used to pay off the outstanding balance owed to the lender.