Buydown

What Is a Buydown?

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. 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 Explained

Buydowns are easy to understand if you consider them a mortgage subsidy made 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. This lower payment allows the homebuyer to qualify more easily for 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.

Homebuyers may choose an adjustable-rate mortgage (ARM) if they plan to refinance once the initial rate term ends or if they plan to sell the property before the rate adjusts.

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. 3-2-1 and 2-1 mortgage buydowns are two common structures.

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. These payments are offset by the buydown contribution made by the seller.

For example, a homebuyer who has received a 6.75% fixed interest rate on a $150,000 loan for 30 years would have lower payments in the first three years. In year one, they would pay 3.75% interest; in year two, 4.75%; and in year three, 5.75%. In the years following the first three years, their payments would increase to the standard rate of 6.75% or $973 monthly.

While they 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.

Important

Consider the interest rates for which you’re likely to qualify, based on your credit history and income, to determine if a buydown is worth it.

2-1 Buydown Pros and Cons

Whether it makes sense to use a 2-1 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 breakeven point.

Pros Explained

Cons Explained

Remember to consider both the up-front costs of buying a home, such as the down payment or closing costs, and the ongoing costs to understand how much you can afford to become a homeowner.

Example of a 2-1 Buydown Mortgage

If a borrower received a $100,000 loan for 30 years at a 6.75% fixed interest rate, then they could lower their payments in the first two years with a 2-1 buydown. In a 2-1 buydown, they could pay 4.75% interest in year one and 5.75% interest in year two. In the years following, their payments would increase to the standard rate of 6.75%, and they would pay $649 monthly.

The savings obtained in the first two years would have been offset by subsidy payments from the seller to the lender, thus providing the buyer with the two-year discount.

When to Use a 2-1 Buydown

A 2-1 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.

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.

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. 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.