When you make the decision to purchase a home, you’re not just committing to paying the purchase price of the property but also the interest rate on your mortgage loan – the cost of borrowing money from your mortgage lender.
Despite recent decreases in interest rates, many homebuyers are still exploring ways to make the homebuying process more affordable. While waiting for mortgage rates to drop further may seem tempting, there’s no guarantee that they will. This is where mortgage rate buydowns come into play.
By paying a little extra upfront, you can secure a lower mortgage rate and keep more money in your pocket each month.
Understanding Mortgage Buydowns
A “mortgage buydown” is a financing agreement where the buyer, seller, or builder pays mortgage points, also known as discount points, at closing to secure a lower interest rate. This one-time fee is paid at closing in exchange for a reduced interest rate.
There are various methods of buying down a mortgage, depending on your lender and whether you prefer a permanent or temporary mortgage buydown rate.
Permanent vs. Temporary Buydowns
A mortgage buydown can be implemented over a fixed period or the entire duration of the loan.
Permanent Mortgage Buydown
With this option, you can secure a lower rate for the entire loan term at closing through discount points. Unlike a temporary mortgage buydown, the rate will not increase.
Temporary Mortgage Buydown
In this scenario, your mortgage interest rates will be reduced for a specific period before reverting to the standard amount. Temporary mortgage buydown structures are often referred to as “3-2-1 buydown” or “2-1 buydown”. Details on each arrangement will be discussed later.
Cost of a Mortgage Buydown
Typically, each mortgage point a borrower pays equals 1% of the loan amount and usually decreases the interest rate by 0.25%. For example, one point would lower the mortgage rate from 6% to 5.75%. However, the reduction in rate per discount point may vary among lenders.
Example of a Mortgage Buydown
Let’s assume a mortgage lender offers the borrower the option to reduce the interest rate by 0.25% by purchasing one point. If the loan amount is $500,000 and the interest rate is 6%, the borrower can lower their rate to 5.75% by paying $5,000 (1% of $500,000) upfront.
Considerations for Mortgage Buydowns
A mortgage buydown can be a strategic move to lower your monthly payment, particularly in a high-rate environment. However, it may not be suitable for every buyer. The decision to pursue a buydown depends on who is covering the cost, how long you intend to stay in the property, and whether you seek short-term or long-term payment relief.
A mortgage buydown is recommended if:
If a seller or builder is covering the cost.
If you desire a lower payment in the initial years.
If you plan to reside in the home long enough to justify the upfront expense.
If you are purchasing when interest rates are relatively high.
Instances when a Mortgage Buydown may not be ideal
A buydown may not be the best option if:
- You are short on cash after covering your down payment and closing costs
- You plan to sell or refinance shortly
- You prefer to allocate the funds towards increasing your down payment
In certain cases, allocating additional funds toward your down payment or maintaining them in savings may offer more flexibility than investing in discount points.
Varieties of Mortgage Buydowns
There are three common structures for temporary mortgage buydowns: the “3-2-1 buydown”, the “2-1 buydown”, and the “1-0 buydown”. Learn about each of these options below:
Understanding the 3-2-1 Buydown
A 3-2-1 buydown enables the borrower to enjoy reduced interest rates for the first three years of the loan. The interest rate is three percentage points lower than the current rate in the initial year, increasing by a percentage point annually for the subsequent two years. By the fourth year, the rate will align with the rate secured at the beginning of the mortgage.
Refer to the table below to observe how a 3-2-1 mortgage buydown affects the buyer’s monthly mortgage payment on a $400,000 30-year loan with a 6% interest rate.
The number of mortgage points charged for the buydown may vary among lenders, but typically the buydown cost is approximately equal to the amount the buyer saves in interest. Using the example above, the mortgage buydown cost would be around $17,412.
Understanding the 2-1 Buydown
A 2-1 mortgage buydown follows a similar structure to the 3-2-1 format, except the discounted rate is applicable only for the initial two years of the loan term. This would provide the buyer with an interest rate 2% lower than the standard rate in the first year and 1% lower in the second year.
Using the same example, a $400,000 30-year loan with a 6% standard interest rate, let’s examine how a 2-1 buydown would unfold.
In the initial two years of the loan term, the buyer would save approximately $8,868 in interest. With this information, we can anticipate the cost of the 2-1 buydown to be roughly the same.
Understanding the 1-0 Buydown
A 1-0 buydown involves a 1% reduction in interest rates solely in the first year. Refer to the table below to observe how this structure plays out over a $400,000 30-year loan.
Utilize a monthly mortgage calculator for an estimated monthly payment based on varying interest rates.
Pros and Cons of Mortgage Buydowns
Under the right circumstances, a mortgage buydown can be advantageous for both buyers and sellers. Understanding your situation and being aware of the associated costs can help you navigate potential challenges.
Who Covers the Cost of a Mortgage Buydown?
While the buyer ultimately benefits from a mortgage buydown, sellers and builders may also opt to purchase discount points to lower the buyer’s interest rate.
Cover the Cost Personally
A mortgage buydown is typically negotiated between a buyer and their lender. If you have additional funds after accounting for your down payment, you can use this money to acquire mortgage points upfront for a reduced interest rate.
Request the Seller to Cover It
If a seller is looking to sell their home quickly or is in a buyer’s market, they may offer to pay for a mortgage rate buydown as an incentive for buyers. In this scenario, the seller will make a one-time deposit into escrow or pay points over the loan term as part of seller concessions, or the closing costs the seller has agreed to cover. While this action provides the mortgage lender with the necessary funds to lower the buyer’s interest rate for easier affordability, the seller may attempt to offset the expense by adjusting the purchase price of the property.
Utilize a Builder Closing Cost Incentive
Homebuilders might offer financial incentives for purchasing their newly constructed properties. These funds can be utilized to cover closing costs, including buying down your rate.
Utilize Gift Funds
If you have received funds as a gift from a family member or close friend, you can apply this money towards a mortgage rate buydown. However, there are limitations on the amount you can receive as a gift without incurring a gift tax.
FAQs about Mortgage Buydowns
What are Some Alternatives to Mortgage Buydowns?
Adjustable-rate mortgages (ARM) and refinancing are potential alternatives for individuals seeking to save on their mortgage payments.
It’s essential to remember that both options are subject to market rate fluctuations. Refinancing is only beneficial if interest rates decrease, whereas an ARM could lead to higher payments if rates rise.
What are Other Ways to Lower my Interest Rate?
If you wish to minimize your interest expenses without additional upfront costs, consider taking steps to boost your credit score. A higher credit score can secure a lower interest rate on your mortgage, thereby reducing your monthly payment.