A buydown is a helpful financial tool that helps borrowers get an affordable rate for a few years during the loan term. The financing method is useful if the borrower wants to lower their monthly payments for a specific period.
Understanding what is a buydown can be a bit challenging; fortunately, you’re in the right place. I’ve been teaching real estate for years. One thing I see people always struggle with is understanding real estate finance terms like buydowns.
In this post, I’ll define buydowns in the mortgage industry and provide a few examples to clarify the concept. Let’s dive into the details!
What Is a Buydown?
A buydown is a financing process in which the borrower obtains a lower interest rate for a few years during the loan term by paying more upfront. By paying a bigger lump sum upfront, buy down allows the borrower to pay a lower interest rate for some years. A buydown can help the borrower save on interest during the life of the loan. Borrowers use the buydown technique to reduce the interest rate per month and the monthly payment.
However, to balance the cost, the property’s seller or builder also increases the property’s price. Interest rate plays an essential role in the cost of a loan; thus, it is important to compare the rates. To understand how buydowns work, it is essential to know the percentage points. A buydown may involve purchasing mortgage or discount points against the loan for which the borrower might have to pay an up-front fee.
Mortgage/ Discount/ Percentage Point
A mortgage point is also known as a discount or percentage point. These points refer to the fees the borrower has to pay to the lender to reduce the interest rate on the mortgage. Each point is equal to 1% of the mortgage amount. Thus, one point on a $200,000 mortgage will cost $2000. Every mortgage point lowers the interest rate by 0.25%, but how much the point affects the rate varies from lender to lender. The higher the rate-reducing power of a point, the lower the interest rate or payments.
Break Even Point
The borrower must calculate the break-even point to determine whether a buydown would be useful. The break-even point can be calculated by dividing the total cost of the mortgage points by the monthly savings. For example, if a lender allows you to buy 5 discount points to lower the interest rate by 1%, with a 30-year, $300,000 mortgage at an interest rate of 4%. The cost of reducing the interest rate by 1% would be: 0.05 X $300,000 = $15,000. The monthly savings are the amount obtained by subtracting the mortgage payment at the new rate from the mortgage payment at the new rate.
- Original monthly payment at 4%: $1,432.25
- Reduced monthly payment at 3%: $1,264.81
- Monthly savings: $1432.25 – $1,264.81 = $167.44
- Break-even point: $15,000/167.44 = 89.58
This means that it would take around 89 to 90 months to recover the money that the borrower spent to lower the interest rate. Thus, the buy-down would be beneficial if a buyer plans to stay in the house for more than 89 months. This is how the break-even point helps borrowers determine whether they should go for a buy-down.
How Does a Buydown Work?
A buydown works by allowing the borrower to buy points. Buydown is a subsidy a home buyer gets on the seller’s behalf. The rates and terms of a mortgage buydown vary from lender to lender depending on the type of Buydown. A buydown can be temporary or permanent. While some buydowns cover the entirety of the loan, others are only temporary. The following are ways in which the mortgage work:
Temporary Mortgage Rate Buydown
A temporary mortgage rate buydown lowers the interest rate for the first few years but then increases. The low-interest rate is for a predetermined period. For this type of mortgage, the borrower can choose a rate 3% lower than the current mortgage rate.
For instance, if the market rate is 6%, a temporary buydown would allow the borrower to repay the monthly amount at 3% for a few years. The rate increases according to the buy-down structure in this type of buydown. The final rate remains fixed throughout the remaining term. The cost of purchasing the points for lowering the rate is paid at closing.
Permanent Mortgage Rate Buy Down
A permanent rate buydown lowers the interest rate for the entire loan term. The lender charges for the discount points that lower the interest rate permanently. The more discounts the borrower purchases, the more the interest rate reduces. The rate doesn’t increase during the loan term unless it is an adjustable mortgage. Again, purchasing the mortgage points adds to the mortgage cost, which is paid at closing.
A few types of buydown structures are used with the temporary rate buy-down. The most popular are the 2-1 buy-down and the 3 – 2 -1 buy-down. Both structures follow the same principles, but the timing of rate application is different.
A 2-1 buydown is a mortgage in which the buydown applies for the first two years. This is a temporary rate buy-down in which the interest rate lowers for the first two years and remains fixed for the remaining term. In a 2 -1 buy-down, the borrower pays 2% less interest on the mortgage for the first year and 1% less interest rate for the second year. After the second year, the borrower has to pay the full interest rate during the remaining term.
A 3 – 2 – 1 buydown is a temporary rate buydown that allows the borrower to pay a lower interest rate for the first three years. During the first year, the buyer pays a 3% lower interest rate on the mortgage. For the second year, the buyer pays a 2% lower interest rate, and for the third year, they pay 1% lower. The borrower pays the full interest rate from the fourth year onwards until the remaining loan amount.
Whether the buydown is right for the borrower depends on several factors. For instance, the break-even point, income, period of property ownership, etc. The following are the main benefits of a buydown:
- It lowers the interest rate, which reduces the monthly payments during the initial stages of the loan.
- A temporary rate buydown allows the borrower to save on interest if the borrower is short on budget. This is a good option for the borrower if they expect their income to rise in the later years.
- The homebuyer can also take the help of the builder. The builder can pay the buydown on behalf of the buyer and, in turn, increase the property’s price.
Though there are many benefits of a buydown for the borrower, there are a few drawbacks too. The following are the main disadvantages of a buydown:
- To qualify for a buydown, the borrower must have enough cash to pay a 20% down payment.
- Once the buydown rates end after the initial years are over, the rates increase, which increases the monthly payments.
- If the borrower cannot make high monthly payments during the later stages of the loan, they will default on the loan. This will allow the lender to foreclose the property, and the borrower will lose the property.
Example 1: Suppose John is borrowing a $315,000 loan at a rate of 6%. The term for this loan is 30 years. John decides to lower the interest rate by choosing a 2 – 1 buydown. For the first year, the interest rate will be lower by 2%. This mortgage will look like this during the first few years:
- Year 1: $1,503.86 at 4%
- Year 2: $1,690.99 at 5%
- Year 3: $1,888.58 at full interest, which is 6%
As you can see, John has to pay a lower interest rate of 4%, which is 2% less than the original rate. This rate increases by 1% in the second year and again by 1% in the third year to reach the actual interest rate. After year 2, John has to make monthly payments of $1,888.58 for the entire term, which is 28 remaining years in the 30-year mortgage.
Example 2: Suppose Sandra wants to get a loan of $475,000 at a rate of 7%. Sandra wants to lower the interest rate for the first three years of the mortgage term. This is because she will get a promotion after three years, which will allow her to make higher monthly payments on the loan. Thus, she chooses a temporary rate buy down with a structure of 3 – 2 – 1. With this buydown structure, Sandra will pay a lower interest rate during the first three years. The following is a breakdown of the buydown mortgage:
- Mortgage amount: $475,000
- Interest rate: 7%
- Mortgage term: 30 years
- Year 1: $2,267.72 at 4%
- Year 2: $2,549.90 at 5%
- Year 3: $2,847.86 at 6%
- Year 4: $3,160.19 at a full interest rate, that is 7%
As you can see, the interest rate in the first year is 3% less than the original rate. The rate increases by 1% in the second year, which is 2% less than the original rate. In the third year, the rate decreases further by 1% and is 1% less than the original rate. In the fourth year, the borrower pays full interest at 7% for the remaining term.
Frequently Asked Questions
How to Qualify for a Buydown?
Most lenders mostly require at least a 20% down payment and a good credit score to qualify for a buydown. A good credit score is between 670 and 739, and a score above 739 is considered very good. If the borrower qualifies for a buydown, they can purchase mortgage points to lower the interest rate. Some lenders might put a limit on the number of points that a borrower can purchase.
How to Pay for a Mortgage Buydown?
There are different ways to pay for a buydown mortgage. The borrower can pay cash, ask the seller to pay, use gift funds, or use a builder closing cost incentive. If the borrower has some extra cash, they can make the payment, but it is recommended to do the break-even math first. Besides that, the homebuyer can also ask the seller to pay for a lower buydown rate. Some home builders offer incentives to help borrowers cover closing costs, including the buydown rate.
What to Know for the Real Estate Exam
A buydown is a technique that allows the borrower to temporarily or permanently lower the interest rate during the loan term.
The interest rate lowers when the borrower purchases percentage or discount points which lower the rate by a certain percentage of the loan amount. These points are paid at the loan’s closing as a one-time fee. The number of points that a borrower can purchase depends on the lender.
There are benefits and drawbacks of a buydown mortgage, but a borrower can determine if the buydown is beneficial using the break-even point method.
Do you want to learn more about such real estate terms? Go through this extensive Real Estate Vocabulary to prepare for your exam better.