Whats a Buydown Loan?

What Is a Buydown Loan?

A buydown is a mortgage financing technique with which the buyer attempts to obtain a lower interest rate for at least the first few years of the mortgage or possibly its entire life.1 A 2-1 buydown, for example, is a specific type of mortgage buydown that allows homebuyers to save on their interest rate for the first two years of the loan. Buydowns can also use a 3-2-1 structure as well.

Understanding Buydowns

Buydowns are easy to understand if you think of them as a mortgage subsidy offered by the seller on behalf of the homebuyer. Typically, the seller contributes funds to an escrow account that subsidizes the loan during the first years, resulting in a lower monthly payment on the mortgage. Builders or sellers may offer a buydown option to help increase the chances of selling the property, by making it more affordable.

The builder or seller of the property usually provides payments to the mortgage-lending institution, which, in turn, lowers the buyer’s monthly interest rate and, therefore, monthly payment. The home seller, however, usually will increase the purchase price of the home to compensate for the costs of the buydown agreement.

Buydown Structuring

Buydown terms can be structured in various ways for mortgage loans. Most buydowns last for a few years, then the mortgage payments increase to a standard rate once the buydown expires. A 3-2-1 and 2-1 mortgage buydown are two common structures lenders can use.

3-2-1 Buydown

In a 3-2-1 buydown, the buyer pays lower payments on the loan for the first three years. For each of the first three years of the mortgage, the buyer’s interest rate would increase incrementally by 1% annually. The full interest rate would apply beginning with the fourth year of the mortgage loan.

While the buyer received savings from the lower interest rate in the first three years, the difference in the payments would have been made by the seller to the lender as a subsidy.

2-1 Buydown

A 2-1 buydown is structured the same as a 3-2-1 buydown; however, its discount is only available for the first two years. So you would have a 2% interest rate reduction for the first year of the mortgage, then a 1% rate discount for the second year of the mortgage. Your interest rate—and your monthly payments—would increase over time until your loan reaches its actual percentage rate.

This happens in year three of the loan. At this point, your monthly mortgage payment would reflect the true loan rate. You would pay up front for the 2-1 buydown at closing, and, theoretically, the money that you save over the first two years would cancel out that payment.

Buydown Pros and Cons

Whether it makes sense to use a buydown to purchase a home can depend on several things, including the amount of the mortgage, your initial interest rate, the amount you could save in interest over the initial loan term, and your estimated future income. How long you plan to stay in the home also can come into play for determining your break-even point.

Pros Explained

• Interest savings. Choosing a buydown could save you money on interest costs during the first two years (with a 2-1 buydown) or three years (with a 3-2-1 buydown) of the mortgage.
• Price reduction. If a seller is offering to pay something toward the buydown, then this could reduce the cost of buying the home.
• Ease into higher payments. If you’re just starting your career and your income is expected to rise, then you may not have any issues with making your higher mortgage payments over time.

Cons Explained

• Ongoing affordability. Once the initial rate period ends, your monthly payments could be substantially higher than what you’re used to. That could be problematic if your income has dropped since purchasing the home.
• Availability. Your ability to take advantage of a buydown may be limited by the type of property involved or the type of mortgage loan for which you’re applying.
• Default risk. If you’re not able to make the higher payments after the initial buydown period then you could be at greater risk of losing the home to foreclosure.

Example of a Buydown Mortgage

Here are some examples of how a buydown mortgage can work. Say you’re borrowing $250,000 with a 30-year fixed-rate loan at 6.75%. You can choose between a 2-1 buydown or a 3-2-1 buydown.

Here’s what the loan breakdown would look like with a 2-1 buydown option:

• Year 1: $1,304 at 4.75% interest
• Year 2: $1,459 at 5.75% interest
• Year 3: $1,622 at full 6.75% interest

The buydown fee for this loan would be $5,759. Now, say you choose the 3-2-1 buydown instead. Here’s what your loan payments would look like:

• Year 1: $1,158 at 3.75% interest
• Year 2: $1,304 at 4.75% interest
• Year 3: $1,459 at 5.75% interest
• Year 4: $1,622 at full 6.75% interest

Meanwhile, the buydown fee for this loan increases to $11, 324. So when considering a buydown, it’s important to look beyond the initial low payment period to determine whether the costs involved in the near term are worth any interest savings you might realize.

When to Use a Buydown

A buydown could make sense for buyers if it allows them to get a mortgage without significantly increasing the purchase price of the home or draining their cash reserves. Buydowns also may be more appropriate for people who have stable income set to grow over the life of the loan, making it easier to keep up with payment increases once the initial rate period ends.

But again, timing matters. If you don’t plan to stay in the home for at least five years, then you might not see any real savings at all from a buydown. So consider your future plans for buying a home and how long you might stay put before committing to a mortgage buydown.

Also, remember that not every mortgage is eligible for a buydown. For example, you can’t use them to purchase an investment property or for cash-out refinancing. Government-backed loans, such as FHA loans and USDA loans, also have specific guidelines regarding buydowns and when they can be used.

Other Ways to Reduce Mortgage Rates

Alternatively, buyers can choose to pay for discount points to buy down their interest rate. In this scenario, the buyer pays money up front to purchase the points, and the lender reduces their interest rate as a result. Discount points can lower the interest rate on a mortgage for the life of the loan, rather than just for the first two years.2

A buydown is not the same as an adjustable-rate mortgage (ARM), in which the rate is fixed for a set period of time before adjusting to a variable rate.3 A 5/1 hybrid ARM, for example, has a fixed rate for the first five years, with the rate adjusting annually each year after that, based on the performance of an underlying benchmark rate.