It’s widely known that purchasing a home can be a costly endeavor. When you secure a mortgage, you’re agreeing to cover the home’s purchase price and committing to paying for the opportunity to borrow money.

A buydown is a financial strategy that allows you to secure a lower interest rate on your mortgage by paying discount points at the time of closing. Discount points, sometimes called mortgage points or prepaid interest points, involve an upfront, one-time fee. When discount points are utilized, they result in a reduced interest rate.

Understanding the Costs of Buying Down an Interest Rate

The cost of each discount point is directly tied to the loan amount and is calculated as a percentage of the loan amount. For instance, a lender may offer you the option to lower their interest rate by 0.25% in exchange for a single point. To illustrate, if you are seeking a $400,000 mortgage at a 4% interest rate, paying $4,000 in points would reduce their interest rate to 3.75%.

Temporary Buydown

In an alternative form of buydown, the points purchased for a temporary buydown decrease the interest rate for a specific duration of time at the beginning of the loan. This arrangement is typically funded through an escrow arrangement facilitated by the seller. As a result of the lower interest rate during this period, your monthly mortgage payments become more affordable.

Given the forecasted upward trajectory of mortgage rates in 2022, the buydown method emerges as a popular and valuable tactic to safeguard against impending rate increases. To determine if this strategy suits your situation, compare today’s rates with prevailing market rates and explore your loan options.

Who Can Employ a Mortgage Buydown?

Although you, the buyer, are the primary beneficiary of a buydown, initiating this strategy is not solely your responsibility. Sellers and builders can also play a role in purchasing points to lower the buyer’s interest rate.

  • Buyers: The majority of buydowns occur through negotiations between buyers and lenders. Homebuyers agree to pay a specified number of points upfront, reducing interest rates. The duration of the lower interest rate depends on the buydown structure, spanning several years or the entire loan term.
  • Sellers: Sellers may opt to buy down a buyer’s mortgage to incentivize their property purchase. In such cases, the seller makes a one-time payment or funds points throughout the loan term via seller concessions. This financial assistance lets the lender lower the buyer’s interest rate, making homeownership more attainable. However, sellers may adjust the home’s purchase price to account for this expense in a seller’s market.
  • Builders: Builders may also use this strategy to attract early buyers to newly developed communities.

How Temporary Buydowns Are Structured

Temporary buydowns are flexible arrangements that can be structured in various ways. Typical structures include the 1-0 buydown and the 2-1 buydown, with the 3-2-1 buydown being less common. Regardless of the structure, the fundamental principles remain consistent.

Under a temporary buydown arrangement, the seller or builder pays the lender the difference between the standard interest rate and the reduced rate buydown subsidy cost at closing. The buyer benefits from the reduced interest rate for a specified period, usually a few years. Some buydowns do not have expiration dates, but if they do, the buyer must revert to the standard interest rate, resulting in higher monthly mortgage payments. In the examples below, the cost for the temporary buydown is also referred to as the Total Combined Subsidy Amount.

  • 1-0 Buydown: This temporary buydown option reduces the interest rate by 1% for the first year of the mortgage and then reverts the mortgage interest rate back to the contract interest rate for the remainder of the loan term.

Here’s what a 1-0 Temporary Buydown looks like for a 30-year fixed with a $400,000 loan amount at a contract rate of 7% interest.

  • 2-1 Buydown: This temporary buydown option reduces the interest rate by 2% for the first year, 1% for the second year, and then returns back to the contract interest rate for the remainder of the loan term.

Here’s what a 2-1 Temporary Buydown looks like for a 30-year fixed with a $400,000 loan amount at a contract rate of 7% interest.

  • 3-2-1 Buydown: In this scenario, the temporary buydown option reduces the interest rate by 3% for the first year, 2% for the second year, 1% for the third year, and then reverts back to the contract interest rate for the remainder of the loan term.

Here’s what a 3-2-1 Temporary Buydown looks like for a 30-year fixed with a $400,000 loan amount at a contract rate of 7% interest.

The cost of the buydown typically corresponds to the amount saved in interest. For example, a 2-1 buydown could cost around $9,320, saving the buyer a similar amount in interest payments.

Evenly Distributed Interest Rate Reductions

In some cases, buyers may opt to purchase enough discount points to reduce their interest rate over the entire loan term evenly. This approach involves a larger upfront payment, ensuring the interest rate and monthly mortgage payments remain constant. While it results in higher upfront costs, it prevents future increases in mortgage payments.

For instance, a buyer with a $400,000 loan, opting to buy down the interest rate to 4%, would maintain a fixed monthly payment of $1,909.66 throughout the loan’s term.

It’s worth noting that this type of buydown is more costly, typically ranging from $16,000 to $20,000, but offers substantial long-term savings. It’s most suitable for buyers planning to stay in their homes for an extended period.

Should You Buydown Your Mortgage Rate?

Buydowns are advantageous when sellers or builders cover the cost of discount points without significantly increasing the home’s purchase price. However, if buyers plan to cover the points themselves, several factors come into play.

Firstly, buyers must have sufficient savings for a down payment and closing costs while retaining a substantial cash reserve. This strategy can be beneficial if buyers anticipate a significant increase in their income in the future, such as graduate students expecting higher incomes post-graduation or stay-at-home parents planning to return to work.

However, it’s crucial to remember that buydowns entail upfront expenses to realize long-term savings. Therefore, they are most suitable for buyers with a long-term commitment to homeownership.

Calculating the Breakeven Point

To determine if a buydown is worthwhile, it’s essential to calculate the breakeven point. The breakeven point represents the time it takes to recoup the cost of the discount points through monthly savings. The formula for calculating the breakeven point is:

Breakeven Point = (Cost of Points) / (Monthly Savings)

For example, if you are considering a 30-year, $400,000 mortgage with an interest rate of 5%, and paying four points reduces the interest rate by 1%, the points cost $16,000. With monthly savings of $237.63, the breakeven point would be approximately 67 months, or about five years and seven months.

Buydowns may not be suitable for buyers planning to sell or refinance before reaching the breakeven point. In such cases, alternative strategies like making extra payments to reduce interest costs may be more appropriate.

Are There Limits on Temporary Buydowns?

It’s essential to consult with a lender when considering a temporary buydown, as certain restrictions apply:

  • Temporary buydowns are typically applicable to primary residences and second homes.
  • Investment properties and cash-out refinances are ineligible for temporary buydowns.
  • Adjustable-rate mortgages (ARMs) generally require an initial interest rate period of at least three years for temporary buydown eligibility.
  • State-specific regulations may limit seller subsidies.
  • Federal programs, such as FHA loans, restrict temporary buydowns based on the type of mortgage and the purpose of the loan.

In Conclusion, Buydowns Can Lead to Savings

In summary, mortgage buydowns effectively allow you to lower your monthly mortgage payments permanently or during your loan’s initial years. You can secure reduced interest rates by paying discount points at closing, resulting in long-term savings.

However, buydowns are not a one-size-fits-all loan feature, so you should calculate your breakeven point to ensure the time it will take to recoup the money spent on any buydown is worth your upfront investment.