What Is a Buydown?
A buydown is a strategic mortgage financing method that enables buyers to secure a reduced interest rate for the initial years of their mortgage or even throughout its entirety. An example is the 2-1 buydown, where homebuyers benefit from a lower interest rate for the first two years of the loan. Buydowns may also follow a 3-2-1 structure.
### Key Takeaways
– A buydown grants homebuyers access to lower interest rates when securing a mortgage.
– Savings on interest expenses throughout the loan term are potential with buydowns.
– Buydowns may involve purchasing discount points against the loan, potentially necessitating an initial fee.
– The decision to opt for a buydown when purchasing a home could be influenced by qualifying interest rates and the buyer’s long-term residency plans.
Understanding Buydowns
Buydowns can be simplified as a mortgage subsidy facilitated by the seller on behalf of the buyer. Typically, the seller contributes to an escrow account, subsidizing the loan in the initial years, leading to reduced monthly mortgage payments. Builders or sellers might offer buydown options to enhance property affordability and expedite sales.
The property seller typically disburses payments to the mortgage lender, thereby decreasing the buyer’s monthly interest rate and subsequent payment obligations. It is common for the home seller to adjust the property price to offset the expenses associated with the buydown agreement.
### Tip
Homebuyers may consider adjustable-rate mortgages (ARMs) if planning to refinance post-initial rate term expiration or sell the property before rate adjustments occur.
Buydown Structuring
Buydowns can be structured diversely for mortgage loans. Typically, buydown durations span a few years, after which mortgage payments revert to standard rates post-expiry. Common structures include the 3-2-1 and 2-1 mortgage buydowns.
### 3-2-1 Buydown
In a 3-2-1 buydown, buyers enjoy reduced payments for the initial three years, with interest rates incrementally rising by 1% annually during this period. From the fourth year onward, the full interest rate applies.
While buyers benefit from lower interest rates in the initial years under this structure, the seller compensates for the payment difference sent to the lender as a subsidy.
### 2-1 Buydown
Mirroring the 3-2-1 buydown, the 2-1 variant offers a discount limited to the initial two years. Consequently, a 2% interest rate reduction occurs in the first year, followed by a 1% decrease in the second year. Subsequently, the interest rate and monthly payments gradually increase till the loan reaches its actual percentage rate in year three.
The buyer covers the cost of the 2-1 buydown upfront during closing, and the savings accrued in the initial two years ideally offset this payment.
### Important
Evaluate the probable interest rates based on your credit history and income to assess the viability of a buydown.
Buydown Pros and Cons
Deciding whether to use a buydown hinges on factors like the loan amount, initial interest rate, potential interest savings during the initial term, and your anticipated income growth. The duration you plan to reside in the property is also pivotal for determining the breakeven point.
### Pros
– A buydown temporarily decreases your interest rate, cutting costs and dropping payments initially.
– Opting for a buydown might lead to paying less for the home compared to the listed price set by the seller.
– It could suit homebuyers with anticipated income growth in the coming years.
### Cons
– Post buydown rate expiration, higher-than-anticipated monthly payments can present financial challenges.
– Not all property types or loan formats may support buydowns.
– A lack of income growth could pose difficulties in meeting monthly mortgage payments.
### Pros Explained
- Interest savings: Opting for a buydown can result in lower interest expenditure during the initial years of a mortgage.
- Price reduction: Seller contributions toward a buydown may diminish the home purchase cost.
- Gradual payment increase: If income growth is projected, accommodating higher mortgage payments might not be a challenge.
### Cons Explained
- Sustainability post-exit rate period: Substantial post-expiration payment increases can be challenging, especially with reduced income.
- Availability limitations: Property or loan type restrictions might limit buydown options.
- Risk of default: Struggling with elevated payments post-buydown term could elevate foreclosure risk.
### Tip
Evaluate both upfront and ongoing costs associated with homeownership to gauge affordability accurately.
Example of a Buydown Mortgage
Consider a scenario where you borrow $250,000 through a 30-year fixed-rate loan at 6.75%, with the choice between a 2-1 or 3-2-1 buydown.
A breakdown of the loan under the 2-1 buydown involves:
- Year 1: $1,304 at 4.75% interest
- Year 2: $1,459 at 5.75% interest
- Year 3: $1,622 at full 6.75% interest
This loan’s buydown fee amounts to $5,759. Alternatively, with the 3-2-1 buydown, the payment structure shifts.
- Year 1: $1,158 at 3.75% interest
- Year 2: $1,304 at 4.75% interest
- Year 3: $1,459 at 5.75% interest
- Year 4: $1,622 at full 6.75% interest
The buydown fee for this extended structure rises to $11,324. It is crucial to look beyond the initial low payment phase when contemplating a buydown and weigh the short-term expenses against potential interest savings.
When to Use a Buydown
Opting for a buydown may be appropriate if it allows for a mortgage without a significant hike in the property price or draining available reserves. Individuals with stable income and anticipated growth could find buydowns more suitable to meet payment increases post-initial rate period.
Consider timing aspects as well. If a long-term residency plan is absent for at least five years, the potential savings from a buydown may be negligible. Therefore, ascertain your future homeownership intentions and expected duration before committing to a mortgage buydown.
Additionally, not all mortgages are eligible for buydowns. Restrictions might apply, such as limitations on investment properties or specific loan types like government-backed loans.
Other Ways to Reduce Mortgage Rates
Alternatively, buyers can choose to buy down their interest rate via payments for discount points. This upfront payment to purchase points results in a reduced interest rate offered by the lender. Unlike buydowns, discount points can effectively lower mortgage interest rates over the loan term, not just in the initial years.
A buydown differs from an adjustable-rate mortgage (ARM), where the fixed rate transitions to a variable rate after a specified initial period. For instance, a 5/1 hybrid ARM maintains a fixed rate for five years, then readjusts annually based on a benchmark rate’s performance.
How Does a Buydown Work?
A mortgage buydown empowers homebuyers to briefly reduce their home loan interest rates during the initial years in exchange for a fee.
How Many Points Can You Buy Down on a Mortgage?
There is no set limit on the number of points individuals can buy down on a mortgage. The allowable points may vary based on mortgage type and terms.
Is It Worth It to Buy Down Points?
A mortgage buydown could be valuable if it leads to interest rate savings during the initial loan term. Before deciding, evaluate buydown fee costs and your tenure in the property to determine the overall savings.
The Bottom Line
By reducing interest payments at the onset of a loan, mortgage buydowns present an opportunity for interest cost savings. When sellers contribute to buydowns, property affordability can increase. Understanding buydown mechanisms expands home purchasing options.