What is a Buydown?
When you consider buydowns in the context of a mortgage subsidy made available by the seller on the homebuyer’s behalf, they become much simpler to understand. A buydown is done by reducing the interest rate by paying interest up front. Buydowns can be used to negotiate the sale of a house, to make it more affordable for the buyer and the seller can use a buydown to attract buyers instead of simply reducing the sales price of the home.
The majority of the time, the seller will make a contribution to an escrow account that will be used to subsidize the loan during the first years of the loan’s term. This will result in a reduced monthly payment on the mortgage. Because of the reduced monthly payment, the prospective buyer will have an easier time meeting the mortgage lender’s requirements. A buydown option could be made available by the builder or the seller in order to assist the likelihood of selling the property by making it more affordable.
In most cases, the builder or the seller of the property makes payments to the financial institution that is providing the mortgage. These payments, in turn, decrease the buyer’s monthly interest rate and, as a result, their monthly payment. However, in order to compensate for the expenses associated with the buydown agreement, the seller of the house will often raise the price for which the home is purchased.
Description of Types of Buydowns
Buydowns can be temporary and or permanent.
An example of a temporary buydown is the 3/2/1 buydown. In this example, the interest rate is reduced by 3% the first year, 2% the second, and 1% the third. In the fourth year you go to the rate you agreed to at closing.
So, if today’s market rate is 7.5%, the first year would be at 4.5%, then 5.5%, then 6.5% then the final rate would be 7.5% for the term of the mortgage. In its simplest terms, it would cost 6% of the loan amount to achieve this buydown: 3+2+1 = 6%. If the loan amount was $400,000 then the cost of the buydown would be $24,000.00. This is considered prepaid interest.
Another type of temporary buydowns can be 2/1 buydown. The structure of a 2-1 buydown is identical to that of a 3-2-1 buydown; however, the reduction offered by the 2-1 buydown is only valid for the first two years.
The other type of buydown is a permanent buydown, where instead of using the prepaid interest to temporarily reduce the rate, a borrower uses the prepaid interest to permanently reduce the rate for the term of the mortgage.
The seller can pay the prepaid interest on behalf of the buyer, making it easier for the buyer to afford the home. This would be a good idea if the seller is willing to negotiate but be cautious as it could be a recipe for disaster for the buyer for two reasons.
First, the buyer still needs to qualify at the market rate which in our example above would be 7.5%, making it harder to qualify for the more expensive home. This in turn doesn’t help the seller open markets to other buyers.
Secondly, even though the buyer gets a big payment discount the first year, they could be in big trouble after the third year. Speculation that rates could improve by the end of the buydown period making it attractive to refinance could be dangerous as there’s no guarantee that rates will be better, and life events happen. So, you may not be able to refinance.
Using the same $400,000 and 7.5% I mentioned before. The payments on a 30-year fixed rate would start at $2019.00 but end up at $2780.00 after the rate adjustments. That’s almost $800 a month in payment increase after just 3 years! This can put extreme hardship on a buyer. Even possibly foreclosure. There’s got to be a better way for first-time homebuyers and there is.
Using the same money as before, to permanently buydown the rate, the seller still pays the 6% of the loan amount toward the permanent buydown which would bring the rate down to 5.5%.
What Are the Pros of a Permanent Buydown?
- The buyer qualifies for the mortgage at 5.5% not the 7.5%. So, more clients can qualify for the home without big discounts on the sale price.
- The rate is fixed for the term of the loan, and they won’t have to hope for market improvements to refinance to a lower rate in the future saving thousands of dollars in additional closing costs for the refinance.
- The seller wins because they counter the cost of high rates and give up much less in price negotiation.
- They also get a big tax-deductible expense at closing. Where a simple price reduction won’t do that.
What Are the Cons of a Permanent or Temporary Buydown?
- Your overall transaction expenses will be greater.
- In time, both your interest rate and your payments will go up.
- If you are unable to afford the increased payment, you run the risk of having your property foreclosed upon.
- You may use all of your financial reserves to pay the buydown mortgage expense.
Some Buydown FAQs:
What kind of rates can I get with a buydown?
Rates are discounted between 1% to 4 % but are always based on current conforming rates.
Are there special requirements for a buydown?
The person paying the buydown needs to understand that they will be paying the prepaid interest (buydown cost) at closing. The prospective homeowner must qualify for a mortgage using the full payment based on the actual interest rate, not the temporary one. For this the person paying the buydown (usually the home buyer), will need to work out their breakeven point to see if a buydown is worth their while.
How would this breakeven point work?
Calculating the moment at which you will be profitable after a buydown is required in order to evaluate its usefulness. The length of time it will take for you to recuperate the cost of the discount points that are necessary to decrease your interest rate is referred to as the breakeven point. In order to do the calculation, divide the total cost of the discount points by the total amount of money saved each month.
The point at which you are no longer losing money is known as the breakeven point (Monthly Savings)
Breakeven Point = (The Cost of Points) / (Monthly Savings)
Let’s look at a basic example of how something like this might function. If you want a 30-year, $400,000 mortgage with a 5% interest rate and your lender charges four points to lower it by 1%, you would first compute the points.
Due to the fact that the cost of each point is equal to 1% of the entire purchase price, the overall cost would be $16,000. Your mortgage payments would be reduced from $2,147.29 to $1,909.66 if you paid 4% interest instead of the regular 5%. As a result, your savings per month would amount to $237.63.
When $16,000 is divided by $237.63, the result is 67.33, which indicates that the breakeven threshold is reached after 67 months. That indicates it would take you around 5 years and 7 months to get your money back from the discount points you would have to purchase.
If you, as the buyer, believe there is a possibility that you may sell the house or refinance it before the 67-month mark, then purchasing a buydown is not in your best interest. Instead, consider making extra payments, as you can save money on interest by paying off your mortgage early.
Can I Refinance a Buydown?
Yes. In fact, in the event that the first mortgage is refinanced during the first three years of its term, the unused portion of the 3-2-1 concessions will be credited against the principal balance of the new mortgage when the new mortgage is closed. When the refinancing deal is finalized, any excess funds are used toward the reduction of the mortgage debt and serve as a principle payment.
Are There Better Alternatives to A Buydown?
Sometimes a long-term ARM, also known as an adjustable-rate mortgage (home loan with variable interest rate) could work as well or better. However, the market rates on those are too high right now.
Let us help you set up the best buydown rates for you.
In conclusion, buying a house is a big investment. Make sure you prepare thoroughly for monthly payments because the amount does matter. Work with a mortgage broker to help you decide on a monthly payment you can afford and how you’ll get there, such as a big down payment, discount points, or a less costly property. Seek to limit spending by budgeting on a 30-year mortgage. Once you’ve determined the monthly payment you can afford, you can estimate what your mortgage payment will be over the 30-year term. Use a mortgage calculator to estimate the interest rate you will pay over the life of your loan. Keep in mind that the most important part of the mortgage equation is the interest rate, because it determines the monthly payment you have to pay over the life of the loan.