Real Estate Investing

What Borrowers Should Know About Buydown Mortgages

April 18, 2024

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A Borrower’s Guide To Buydown Mortgages 

Real estate buyers have a variety of options when it comes to financing. Between fixed-rate, adjustable-rate, bridge, balloon, assumable, and other types of loans, it may be overwhelming to decide which kind of mortgage best suits your needs. 

Buydown mortgages are yet another option. With incentives for both buyers and sellers, buydown mortgages offer an opportunity to take advantage of lower interest rates at the beginning of a loan term at times of high average rates, which are one of the main concerns for home buyers today. 

Making an informed decision on whether a buydown is right for you starts with understanding the fundamentals. In this article, we’ll cover the basics, benefits, drawbacks, and everything else you need to know about buydown mortgages. 

How does Mortgage Financing Work with Buydown Mortgages? 

How does mortgage financing work with buydown mortgages? To understand buydown mortgages, you must grasp the concept of interest rate buydowns. A mortgage buydown is a financing technique involving paying for mortgage discount points upfront in exchange for a reduced interest rate on the loan for the initial years, which helps you save money by reducing your monthly mortgage payments for the first few years. 

Typically, a buyer purchases these points to buy down their mortgage interest rate for either a temporary or permanent period. Temporary buydowns are common and reduce interest rates for one to three years at the beginning of the loan term. Interest rates will gradually increase back up to the original rate over those initial years. There are several types of temporary buydown mortgages that we’ll cover in the next section.  

A subsidized buydown differs in that it involves a third party, like a home builder or seller, who contributes funds to purchase the points and lower the borrower’s initial payments. Why might a seller or builder do this? The main reason is to incentivize the house to sell. If a seller buys down a buyer’s mortgage by making a one-time payment for points and deposits those funds in escrow, the home might be more attractive to buyers looking for lower interest rates and a reduced monthly mortgage payment. However, if the seller does subsidize the loan this way by purchasing points for the interest rate, they will usually also increase the purchase price of the home by the approximate cost of those points. 

Understanding these variations is crucial when considering a buydown mortgage, as each option impacts your overall cost and monthly payments.  

Types of Mortgage Buydowns 

As mentioned above, there are several types of temporary mortgage buydowns: Namely, 3-2-1 loans, 2-1 loans, and 1-0 loans. 

A 3-2-1 buydown mortgage is a mortgage reduces the interest rate by 3% the first year, 2% the second year, and 1% the third year. By the fourth year, the interest rate has increased back to the original loan rate. For example, if you had a loan with an original interest rate of 6% and you lowered the rate with a 3-2-1 buydown, your interest rate would be 3% the first year, 4% the second year, 5% the third year, and 6% from then onward. 

A 2-1 buydown mortgage works the same way as a 3-2-1, except that the interest rate is only reduced for the first two years. If our example from above was for a 2-1 buydown, the first-year interest rate would be 4%, the second-year interest rate would be 5%, and the remaining years would have the full 6% interest rate. 

A 1-0 buydown mortgage reduces your rate by a single percentage point for one year only. 

A permanent buydown is also possible. Permanent buydowns maintain a reduced interest rate for the entire life of the loan, offering long-term savings. 

Each type of buydown has its benefits and considerations, so it’s essential to evaluate which option aligns best with your financial goals. In general, the cost of a buydown is about equal to the interest savings you’d see over that buydown. However, buydowns are still advantageous for folks who plan to refinance quickly, don’t want to risk rising interest rates in an adjustable mortgage, or otherwise have goals that would align well with paying more upfront for the benefit of a lower monthly payment later. 

Pros and Cons of Buydowns 

Considering the types of buydowns discussed earlier, evaluating the pros and cons of each option can help you make an informed decision about your mortgage financing strategy. 

The pros of a temporary buydown include lower initial monthly payments, making it easier to qualify for the loan. This can be beneficial if you expect your income to increase in the future. However, the cons include higher payments after the buydown period ends. 

On the other hand, a permanent buydown offers lower interest rates throughout the loan term, potentially saving you money in the long run. Yet, the downside is that it requires a larger upfront payment.  

Understanding these advantages and disadvantages is key to choosing the right buydown option for your financial goals. 

Buydown Costs and Considerations 

Once you have decided to pursue a buydown mortgage financing technique, it’s crucial to understand the associated costs and considerations. Buydowns typically involve upfront expenses, such as points paid for at the beginning to reduce the interest rate over time. These costs can vary depending on the type of buydown chosen and the lender’s terms, but as mentioned above, generally tend to be equivalent to the amount that would be saved in interest. 

Considerations to include before purchasing mortgage points include how long you plan to keep the property, when/how soon you’ll refinance, interest rate trends in general, closing costs, and the funds you will have available at various points in the loan term.  

For example, if the property is a short-term arrangement that you plan to sell quickly, the upfront costs may not lead to significant savings. However, if you expect your income to increase later in the term but need to qualify for a larger mortgage now, those upfront costs may be worth it to lower your rates and qualify for the loan right away. Understanding these costs and factors will help you make an informed decision regarding buydown mortgage financing. 

How to Qualify for a Buydown 

To qualify for a buydown, you need a stable employment history and a good credit score. Lenders typically look for a consistent work record to ensure that you have the financial stability to meet your mortgage obligations. Having a stable job for at least two years can strengthen your application. 

Additionally, maintaining a good credit score is essential. Lenders use your credit score to assess your risk level as a borrower. A higher credit score demonstrates responsible financial behavior and can help you secure better buydown terms. 

It’s also important to keep your debt-to-income ratio in check, as lenders consider this when evaluating your ability to make mortgage payments. By meeting these criteria, you can improve your chances of qualifying for a buydown.  

Conclusion 

In conclusion, buydown mortgages can offer lower initial interest rates and monthly payments, making homeownership more affordable in the short term. 

However, it’s important to weigh the upfront costs and long-term implications before deciding if a buydown is right for you. 

If you would like to get an idea of what your monthly payments would look like with your buydown mortgage, search for a mortgage rate buydown calculator online, like this one. Calculators can give you peace of mind that you’ve done the calculations correctly, as can reaching out to a mortgage professional with further questions to determine if this financing technique aligns with your financial goals.

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