Mortgage Buydowns

A buydown is a mortgage loan with a below market mortgage rate for a period of time that usually lasts one to three years.  The buydown is a temporary reduction in the mortgage interest rate on the home loan that is paid for by paying additional points at the time of the mortgage loan closing.  The buydown mortgage loan is created by having the homebuyer or another third party, often the seller or a home builder, making a subsidizing payment to the mortgage lender so that the buyer’s mortgage rate and, therefore, monthly mortgage payment are lowered.  The buyer may incur the costs of the additional points or subsidy or the seller may foot the bill for the additional points or the mortgage lender can structure the buy down and fund its with a higher mortgage rate immediately preceding the buy down period over the life of the loan. 

A mortgage buy down is a more popular home loan product used by builders in large subdivisions and by sellers in a slow sales market.  A borrower may want to buy down mortgage rates because they have cash on hand, expect their earnings to go up, but need a lower monthly mortgage payment in the present.  The monthly mortgage payment during the buydown is a fully amortizing principal and interest mortgage payment.

In a mortgage buydown, buyers are essentially paying cash up-front for points, and receiving a reduced mortgage interest rate in return.  However, the buy down is only a temporary reduction in the mortgage rate.  Typically, mortgage buydowns last from one to three years after the home loan is closed.  Each year the mortgage rate will rise by a predetermined amount and the mortgage rate increases will only occur for the two or three years, depending on the type of mortgage buy down.

Each point equals one percent of your total loan amount.  For example, 2 points on a $ 100,000 loan will cost $ 2,000, or 2% of the loan amount.  The more mortgage points paid for the subsidy, the lower the interest rate will be.  If these points can be paid for by the seller as an inducement for the seller to close the transaction, this can be a valuable tool.  The mortgage lender may fund or structure the buydown by charging a higher interest rate over the life is loan, this is not very common as the mortgage lender has to protect against early payoff since their compensation for the lower initial mortgage rate is a higher than market rate in the later years of the mortgage loan.

For some borrowers a mortgage rate buydown is more advantageous than choosing an adjustable loan with a payment option that allows for negative amortization like an Option ARM.  That’s because with mortgage buydown programs your mortgage payment always includes principal and interest.  This means every time you make a payment your mortgage balance grows smaller instead of bigger.  The prospect of experiencing negative amortization is always a must to avoid.  In addition, the mortgage rate increases for a buy down are predetermined and not market influenced once the mortgage loan is signed.

A typical mortgage rate buydown looks like this:

Payments are reduced and figured on a mortgage rate over a specific term of a few years.  The difference between the real interest rate and the lowered interest rate is paid in cash by the seller or sometimes the buyer.  It’s like putting $1200 in the bank and withdrawing $100 every month for 12 months to help make your mortgage payment.

One popular buydown is called the 2-1 mortgage buydown.  This is a 30-year fully amortized mortgage where the interest rate increases 1% every year for the first two years, at which point the interest rate is fixed for the remaining home loan term.

As an example, consider that your mortgage amount is $350,000 and the interest rate is fixed at 6.75% for 30 years.  The buyer or seller will buy down the mortgage interest rate by paying a lump sum.

Here is how the mortgage interest rate would work out over the term of the loan.

First year mortgage interest rate is 4.75%

Second year mortgage interest rate is 5.75%

Years three through 30, the mortgage interest rate is 6.75%

It keeps payments low for 36 months for borrowers whose income is expected to later increase or intend to change the home loan or ownership in the future.  The borrower qualifies for this home loan at the 4.75% interest rate and payment amount. 

The 3-2-1 buydown mortgage is another version of a 30 year mortgage rate buydown.  The interest rate increases 1% every year for the first three years, and then the interest rate is fixed for the remaining term.

These home loans are most advantageous when the seller pays for the buy down.  The most common transactions where the buy down is used are on new homes or new construction.  In these cases, the builder is willing to pay points to induce the buyer with lower monthly mortgage payments and a lower mortgage rate.  Home builders generally prefer to provide incentives to prospective borrowers rather than make absolute reductions in the price of the home. 

The bottom line on these mortgage products is that with the buy down you are able to drop the mortgage rate and monthly mortgage payment on your home loan without incurring the risks associated with of an adjustable rate mortgage or interest only home loan.