What is a “Mortgage Rate Buydown,” and might it be right for me?
A mortgage rate buydown is a specific type of mortgage financing option that is available to homebuyers. It can be an effective way to lower the interest rate on your mortgage and reduce your monthly mortgage payments permanently or for the initial years of the loan. In this article, we will explain what a mortgage rate buydown is, how it works, and its benefits and drawbacks.
“Permanent” Buydowns
A “permanent” rate buydown allows a borrower to lower the interest rate for their life of their mortgage loan by paying upfront fees called “points.” While most lenders offer this option, many borrowers find that the costs outweigh the benefits unless the stay in the home (without selling or refinancing) for an extended period of time. Discuss your plans with your lender to see if this might be a good option for you.
As interest rates have increased recently, and both borrowers and lenders expect (hope) that they will come back down in the not too distant future, temporary rate buy downs have become increasingly popular. For the remainder of this article we will discuss an option commonly referred to as a “2/1 buydown.”
What is a 2/1 mortgage rate buydown?
A 2/1 mortgage rate buydown is a temporary buydown that lowers the interest rate on your mortgage for the first two years of the loan. During this time, you will pay a reduced interest rate that is 2% lower than the current interest rate in the first year and 1% lower in the second year. After the initial period, the interest rate returns to its original level and you will pay the standard rate for the remainder of the loan term.
Another option is referred to as a “3/2/1 buydown” in which the borrower pays a 3% lower rate the first year, 2% lower the second year, and 1% lower in the third year before the interest rate returns to its original level for the rest of the loan. Due to the higher upfront costs, 3/2/1 buy downs are not as popular as the 2/1 option.
How does a 2/1 mortgage rate buydown work?
When you choose a 2/1 mortgage rate buydown, the borrower (or sometimes the Seller) agrees to pay additional upfront fees to reduce the interest rate on your loan for the first two years. The number of points you can pay depends on the lender and the terms of your mortgage. The amount of these fees is equal to the “saved” interest over the 2 years.
For example, if you purchase a $420,000 home with $20,000 down payment and take out a $400,000 mortgage with a standard interest rate of 6%, your principal and interest (P&I) payment each month would be $2,398.20 (note that this does not include taxes, insurance, HOA fees, etc.). With a 2/1 buydown, your first year rate would be 4% and your P&I payment would be $1,909.66 per month - a savings of $488.54 per month or $5,862.49 for the year. Your second year rate would be $2,147.29 per month - a savings of $250.92 per month or $3,010.99 for the year. Total “savings” for the two years would be $8,874, which would be the cost of the buydown.
If my savings equals the cost, why would I opt for a temporary buydown?
The benefit of a buydown comes when the Buyer is able to negotiate to have the Seller pay the cost! In some markets Sellers are willing to absorb this cost to get their home sold - talk to your real estate agent or your lender to see if this is an option for your home purchase.
Why not just reduce the price of the home?
If the Buyer is asking the Seller to absorb the cost of the buydown, why wouldn’t they just reduce the total price of the home? Using our example above, let’s assume that the Seller simply reduces the sales price from $420,000 to $411,126 (the same “cost” as the $8,874 buydown). WIth the same $20,000 down payment, the Buyer’s new mortgage is $391,126. At a 6% interest rate, the P&I would be $2,345 per month - a savings of just $53 per month or $1,272 over the two years. Of course this savings would continue for the life of the loan, but the difference over the first two years is much smaller than with the 2/1 buydown.
Benefits of a 2/1 mortgage rate buydown
There are several benefits to using a 2/1 mortgage rate buydown. The most significant benefit is that it can lower your monthly mortgage payments for the first two years of the loan. This can be especially beneficial for homebuyers who may be struggling to make the monthly payments on a new home.
Another benefit of a 2/1 mortgage rate buydown is that it can help you qualify for a larger loan. Lower interest rates mean lower monthly payments, which can increase the amount of money you can borrow. This can be especially useful if you are looking to buy a more expensive home or if you have a limited budget.
If rates drop the buyer may be able to refinance their loan to lock in lower rates… and buy downs can be especially beneficial if you plan to stay in your home for a short period of time.
Drawbacks of a 2/1 mortgage rate buydown
While there are several benefits to using a 2/1 mortgage rate buydown, there are also some drawbacks to consider. The most significant drawback is the upfront cost of the points, especially if the Seller will not cover the cost. Also, a 2/1 mortgage rate buydown may not be available with all lenders or for all types of loans - be sure to check with your lender.