With interest rates at 23-year highs and home prices still soaring, the already expensive undertaking of purchasing a home has become even more costly.
In response to the high cost of borrowing money, many people are searching for ways to reduce their interest and monthly mortgage payments. Others are simply sitting on the sidelines, hoping that interest rates will drop. While waiting for rates to go down may seem like the only option, a buydown mortgage provides another way to relieve the high borrowing cost.
Buydown mortgages have become an increasingly popular method sellers and builders use to entice buyers to purchase homes. Whether you've just started researching how to buy your first home or are already comparing the best mortgage lenders, understanding the basics of a buydown mortgage will put you in a better position when deciding on your home purchase. Read on to learn how a buydown mortgage works, its various types, its advantages and disadvantages, and whether it's the right option.
What is a buydown mortgage?
A buydown mortgage is a financing method in which a buyer pays a lump sum to the lender in exchange for either a permanent or temporary interest rate reduction. The payment to reduce the mortgage rate can be made by the home purchaser, home seller, builder or mortgage lender. Sometimes, the term "discount points" is used and usually refers to a permanent discount on the loan's interest rate.
How does a mortgage buydown work?
Buydowns offered by lenders, builders and sellers are typically structured as a temporary reduction in the loan's interest rate for the first few years of the loan. When purchased by the buyer or seller, they can be considered a subsidy meant to lower the initial payment amount to make it easier on the borrower's budget. Sellers or builders make a lump sum payment up front to the lender, who then holds the funds in escrow. The lender will then apply a portion of those funds to reduce the borrower's interest rate for each year of the buydown period, usually one to three years.
For homebuyers, buydowns typically come in the form of discount points. A discount point, or a mortgage point, is an upfront lender fee paid to reduce the loan's interest rate permanently. One point typically equals 1% of the loan amount (e.g., $3,000 for three points on a $100,000 loan). A discount point can represent a rate reduction of up to 0.25%, depending on the lender and the specific buydown agreement.
Types of buydown mortgages
As with most other kinds of loans, different types of buydown mortgages have their own benefits and unique characteristics. The main two types of buydown mortgages are known as temporary buydowns and permanent buydowns.
As the name implies, temporary buydowns provide a short-term reduction in the loan's interest rate, usually limited to the first one to three years of the mortgage. For multiple-year buydowns, the interest rate typically increases by a certain percentage each year of the buydown period until the loan reaches its final fixed rate.
However, temporary buydowns don’t mean the loan qualification requirements are lower. Borrowers looking into this financing option must still meet lender standards for the higher interest rate to ensure they can afford the loan long-term.
Permanent buydowns reduce the borrower's interest rate throughout the life of the loan. These buydowns usually come in the form of discount points paid as part of the closing costs. More points will result in a larger discount, though the initial cost of the loan will be higher due to the upfront fee.
Each point usually equals 1% of the loan amount and can be used to reduce the interest rate by a fraction of a percent. No government regulations or industry standards limit how many discount points a homebuyer can purchase. However, most lenders typically set a maximum of four to five points per loan.
Mortgage buydown options
Setting permanent buydowns and discount points aside for a moment, the following section examines the different types of buydowns offered by lenders, builders and sellers. These options include 1-0 buydowns, 2-1 buydowns and 3-2-1 buydowns. Each buydown mortgage varies regarding how much they reduce the loan's interest rate and for how long.
A 1-0 buydown is the simplest type of mortgage rate buydown. It involves reducing the loan's interest rate by 1% for the first year of the loan term before the loan reverts to its original, higher rate.
A 2-1 buydown mortgage means the interest rate is reduced by 2% in the first year and 1% in the second year, then increases to the original interest rate for the remainder of the loan term. This type of buydown can provide substantial savings in the early years of the mortgage while allowing borrowers to budget for future adjustments.
The 3-2-1 buydown reduces the interest rate by 3% in the first year, 2% in the second year, and 1% in the third year, after which it increases to the original rate offered. This option is ideal for borrowers who expect a steady increase in their income over the initial years of homeownership.
Buydown mortgage pros
Before deciding whether or not to pursue a buydown mortgage or purchase discount points, it's important to consider what advantages they offer. Luckily, there are two relatively straightforward benefits of buydown mortgages: saving on interest and gradually making higher payments.
Saving on interest
The most obvious advantage of a buydown mortgage is the opportunity to reduce your interest rate. This is especially true for permanent buydowns, where the rate remains permanently lower than it would have been without a buydown.
As for short-term buydowns, the savings are limited but still exist nonetheless. Due to their temporary nature, make sure the buydown will save you money in the long run. Your savings will depend largely on the size of your loan, the cost and length of the buydown program, and the current interest rate environment.
Gradually making higher payments
In addition to saving on interest, many borrowers find that a buydown mortgage is an ideal way to transition into larger mortgage payments. This gradual increase is beneficial if you believe your income will increase during the loan term, as the buydown will allow you to start with reduced payments and then move up to higher payments. Longer buydown programs (e.g., 3-2-1 buydowns) offer the most flexibility in terms of payment, as you have more time to adjust your budget.
Temporary buydowns can also provide time for interest rates to settle lower. If mortgage rates decrease while you’re still in the buy-down period (or close to the end), you can refinance the loan into a permanently lower rate.
Buydown mortgage cons
Although buydown mortgages are a good option for many different types of borrowers, they have some drawbacks you should consider.
Monthly mortgage payments could become too high to afford
While the gradual increase in payments is a benefit, it can also pose a challenge if borrowers' financial situations don't improve as anticipated. When the buydown period ends and the payments increase, borrowers must ensure they can comfortably afford the higher payments.
Risk of foreclosure and financial hardship
If borrowers cannot keep up with the monthly payments after the buydown period ends, they risk falling into default, hurting their credit score or even facing foreclosure. Borrowers should understand the full terms of the buydown mortgage and make sure they fully consider how their financial situation might change before committing to the loan.
Generally speaking, it's a good idea to create future financial projections and talk to a financial advisor to determine if taking on a buydown mortgage is the right choice. In addition, having a financial cushion in place to cover any unexpected costs or situations will help ensure you don't run into any difficulties down the road.
Is it worth buying down mortgage rates?
Permanent buydown mortgages are especially attractive to borrowers who plan to be in their home for a long time and don't expect to be able to refinance soon. Temporary buydown mortgages can provide more flexibility for borrowers who may not stay in the home long-term and are looking to save money on interest now without making a long-term commitment. They are also an excellent option for those who expect their financial situation to improve throughout the loan agreement (e.g. if they are expecting a promotion or raise at work).
For borrowers in a solid financial position and who can afford the higher mortgage payments after the buydown period ends, a buydown mortgage can be an excellent way to save money on interest. However, it is important to consider all the pros and cons before signing any loan agreement. Talk to your lender about your options and carefully review all documentation before deciding on your mortgage.
Why do mortgage companies offer buydown agreements?
As high interest rates and home prices have caused a significant slowdown in the housing market, many mortgage providers have become more creative in finding ways to help borrowers get into new homes. Buydowns can be particularly enticing to first-time homebuyers concerned about initial affordability. By providing options for lower initial payments, lenders can tap into a broader pool of potential borrowers.
However, it's not just home purchasers who can benefit from buydown agreements. Many home builders and sellers also use them to attract buyers. With a tight housing market, offering a buydown option can sometimes be the deciding factor between a home that sells quickly and one that stays on the market for months.
Summary of Money's What is a buydown mortgage
In the realm of mortgage options, the buydown mortgage stands out as a strategy to make homeownership more affordable in the loan's early years. With various temporary buydowns available, borrowers can choose an option that best fits their unique budget and future financial expectations. For example, a buydown mortgage may be a worthwhile option for a borrower to consider if expecting to receive a salary raise or bonus in the near future.
While buydown mortgages offer advantages such as interest savings and gradual payment increases, it's essential to carefully consider the potential drawbacks and evaluate your long-term financial plans before committing to this type of mortgage. By understanding the nuances of buydown mortgages, you can make an informed decision that sets you on a path to successful homeownership with as little financial stress as possible.