Buydown: A way to reduce interest rates

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If you're looking to save money on your monthly payment or on overall interest, an interest rate buydown may be the answer. A buydown allows you to pay a fee when you close on your mortgage for a lower interest rate. You can buy down interest rates on a mortgage for a specific period or for the entire loan term.

Learn more about how buydowns work, how much they cost, the pros and cons, and the limitations.

What is a buydown on a mortgage?

A buydown is a way for a mortgage borrower to reduce their loan's interest rate by paying an extra fee at closing.

The most common buydown option is discount points, also referred to as mortgage points or prepaid interest points. When you buy points, you pay a one-time fee at closing in exchange for a lower mortgage interest rate.

This strategy can save you money on interest over the life of your loan or reduce interest for a set period. When you buy down for a specific time, your interest rate is reduced at the start of your loan term and increases each year until it reaches the initial rate.

How much does it cost to buy down an interest rate?

A mortgage point typically costs 1% of your loan amount and reduces your interest rate by 0.25%.

For example, if you take out a mortgage for $400,000 and you’re initially offered an interest rate of 4.0%, buying 1 point for $4,000 would reduce your interest rate to 3.75%.

Points often can be bought in fractional amounts, so you could buy a half point for 0.5% of the loan amount and reduce your rate by 0.125%.

Who can buy down a mortgage?

Although it’s the home buyer who benefits from a buydown, sellers and builders also can buy points to attract home buyers.

Buyers

Most buydowns are negotiated directly between the buyer and their mortgage lender.

Sellers

Sellers may offer to buy down a buyer’s mortgage to attract offers. To cover this expense, the seller often will add the buydown cost to the purchase price.

“Always remember that seller-funded buydowns typically provide more value than equivalent price reductions on a home for sale,” says Robert Shepherd, CEO of Peak & Home Partners in Rockville, Maryland.

Builders

A home builder also can buy down points to appeal to buyers. Typically, a builder will make an up-front payment to entice early buyers for a new-construction home. Once their communities are established, builders are usually less inclined to offer a buydown.

“Builders often provide a 2-1 or 3-2-1 buydown, paid for out of their sales incentives budget,” says Dennis Shirshikov, a professor of economics and finance at City University of New York-Queens College. “This provides buyers a more gentle payment ramp-up the first year after moving into a new home, amidst all the other costs associated with moving in and buying furnishings.”

Lenders

Lenders also offer rate buydowns as a special deal, either as a temporary buydown effective at the beginning of the term or a permanent buydown for the life of the term.

How buydowns are structured

Since buydowns are negotiated, they can be arranged in multiple ways.

Some buydowns reduce the interest rate for the entire loan term, but you also can buy a temporary buydown. Common structures include a 1-0 buydown, a 2-1 buydown, and a less-common 3-2-1 buydown.

1-0 buydown

With a temporary 1-0 buydown, your interest rate is reduced by 1% for the first year of payments.¹

Here's what that looks like for a 30-year fixed mortgage loan with a $300,000 loan amount at a contract rate of 7% interest.

2-1 buydown

A 2-1 buydown features a rate that’s 2% lower for the first year of the loan and 1% lower in the second year, before settling into the permanent rate starting in the third year.

If you take advantage of this option, you would see the following payment structure and savings for the same sample loan mentioned above.

3-2-1 buydown

A 3-2-1 buydown reduces interest by 1% each year for the first 3 years.²

For example, let’s say a home buyer wants to borrow $300,000, qualifies for a 30-year fully amortized loan at an interest rate of 7%, and decides to take advantage of a 3-2-1 buydown. In this scenario, the buyer would pay an interest rate of 4% in the first year, 5% in the second year, and 6% in the third year. Afterward, the rate would go back to the original 7%.

This chart demonstrates how the buydown would affect this buyer’s monthly mortgage payments:

While the number of points charged for the buydown differs among lenders, the cost of the buydown is roughly equal to the amount the buyer would save in interest. In this case, the total cost of the buydown is $13,756.

Evenly distributed interest rate reductions

Evenly distributed interest rate reductions permanently lower the loan's interest rate. In other words, this buydown doesn’t expire. With this option, a buyer reduces their interest rate evenly and permanently over the loan’s entire term.

This means the buyer pays an even larger sum up front, which prevents their interest rate from increasing.

Using the same example above, the buyer would be expected to pay a monthly mortgage payment of $1,996 for a loan with no mortgage points applied. If the buyer decides they'd rather buy down the mortgage and pay 6% interest throughout the loan’s term, their payments would look like this:

Because the buyer would be lowering their interest payments for the entire life of the loan – instead of just 2 or 3 years – the total cost of the buydown would be higher.

“A permanent buydown is more expensive today, but look at it as long-term savings equivalent to something like paying taxes in the future at a discount right now,” says Michigan-based personal finance expert Chad Silver.

The amount you save on interest depends on the type of mortgage you choose. But it's important to understand your loan terms before considering a buydown.

Should you buy down your mortgage rate?

Buydowns are most beneficial when a seller or builder pays the discount points without significantly increasing the purchase price. If you pay the points yourself, there are circumstances in which buydowns are beneficial.

When you should use a buydown

First, ensure you have enough saved for a house and can cover the down payment and closing costs, and still have some cash left over. Having lower payments in the first few years may be beneficial if you expect your income to be considerably higher in the future.

For example, a buydown may make sense if you are a graduate student who expects your income to double after earning your degree. Buying down the interest rate on a mortgage can also be smart if you are a stay-at-home parent planning to return to work a couple of years after obtaining your loan.

But keep in mind that a buydown is about paying more up front to save money in the long run. That's why buydowns only really make sense if you intend to own the home for a while.

“Buydowns make the most sense when you want lower payments early on, you expect income to increase soon, you are purchasing in a high-rate environment, or a seller or builder is offering concessions,” Shepherd says.

Shirshikov agrees, adding that buydowns can provide psychological security.

“This certainty enables planning for other goals, such as retiring or staying retired, college funds, or investments in a business,” he says. “For temporary buydowns, the structure can also facilitate the move into homeownership by making the payment easier in early years when there may be other economic pressures.”

The break-even point

To determine if a buydown is worthwhile, calculate your break-even point. This is how long it’ll take to recoup the cost of your buydown from your lower interest rate.

To figure out your break-even point, divide the cost of your buydown by the monthly savings.

Example of calculating the break-even point

If you’re looking to obtain a 30-year, $300,000 mortgage with an interest rate of 7%, and your lender charges you 4 points to reduce your interest rate by 1%, you would first calculate the cost of the points.

Since each point costs 1% of the purchase price, the total cost would be $12,000. By paying 6% in interest instead of the standard 7%, your mortgage payments would drop from $1,996 to $1,799. Therefore, your monthly savings would be $197.

Dividing $12,000 by $197 comes to 61, so it would take you 5 years and 1 month for your savings to recoup the money you spent on discount points.

In this scenario, if you think there’s a chance you’d sell your home or refinance before the 61-month mark, a buydown would make no sense. Instead, consider making extra payments applied toward your principal balance, as you can also save money on interest by paying off your mortgage early.

Pros and cons of buying down a mortgage rate

As with any step in the home buying process, it's important to consider the benefits and drawbacks.

Pros

• Lower interest rate and monthly payment: Your interest rate will be lower when you buy down a rate, at least for a portion of the loan term. This means your monthly payment will be lower.
•  More room in your budget: Since your monthly payments will be lower, more of your income will be available for other investments. You could use those funds toward home improvements or repairs.
• Tax deductions: The cost of points can be deducted from your taxes, so if you itemize your deductions, you can save money.

Cons of buydowns

• High up-front cost: A buydown requires you to pay cash up front, which increases your closing costs.
• May not result in savings: If you sell the house before the break-even point, the monthly savings won't offset the up-front cost.
• Eventual larger monthly payments: Most rate buydowns are temporary. You may not be prepared when the discounted rate period ends and your monthly payment increases. You could end up struggling to make the increased payments.

Limits to buying down interest rates

Buydowns are typically only available when buying or refinancing your primary residence or second home. Borrowers need to qualify for a mortgage at the standard interest rate with zero points to buy down the loan.

Investment properties

Real estate transactions that involve investment properties or cash-out refinances usually are ineligible for buydowns. You typically can buy down points on a refinance for conventional loans.

Mortgage type

Buydowns typically apply to fixed-rate mortgages. Adjustable-rate mortgages (ARMs)  are usually eligible for buydowns if they have a fixed introductory rate for at least 3 years. Both temporary and permanent buydowns are available for ARMs, depending on the lender.

State-specific regulations

Some states limit seller subsidies to prevent home prices from becoming overly inflated. In some areas, those limits apply to how many points a seller or a builder can purchase on your behalf.

Government-backed programs                                      

There also are restrictions on government home loan programs. With FHA loans, for example, temporary buydowns are only permitted on fixed-rate mortgages. VA mortgages permit both temporary and permanent interest-rate buydowns. The buydown funds can come from a qualified VA borrower, the seller, or the lender.

Refinances

Temporary buydowns are rare with refinances. Most lenders only permit permanent buydowns.

The bottom line: Buydowns can save buyers cash

Mortgage buydowns allow buyers to reduce their monthly mortgage payments, either permanently or for the first few years of their loan term. If you’re interested in a buydown, calculate your break-even point to ensure you'll recoup the points you paid.

Explore competitive rates offered by Rocket Mortgage, and consider applying for a home loan today.

¹ With the 1-0 temporary buydown, eligible clients will receive a 1% rate reduction below the note rate for the first year of the loan. Offer valid only on retail purchase loans for primary or secondary residences. Not valid on Jumbo, Self-Employed Assist, or Team Member loans. This offer cannot be combined with any other discounts or retroactively applied to previously locked or closed loans. Rocket Mortgage reserves the right to modify/cancel this offer. Additional conditions apply. This is not a commitment to lend.

² Clients may elect a 3-2-1 temporary buydown through seller concessions, home builder credits, and from real estate agent concession, but never more than two sources. With a 3-2-1 temporary buydown, clients may purchase an effective rate reduction of 3% in year one, 2% in year two, and 1% in year three. This product offering is only available on fixed-rate mortgages. Offer valid only on retail purchase loans for Fannie Mae, Freddie Mac, Jumbo Smart (fixed rate only), and VA products. Not available on FHA, cash‑out, rate‑and‑term refinances, or Texas 50(a)(6) loans. Eligible contributors include the seller, builder (if also the seller or agent), real estate agent, and correspondent lender. Client‑earned agent commissions cannot be used. Wholesale brokers and clients cannot fund buydowns. All contributions must meet Seller Concession/Interested Party guidelines. Relocation subsidies cannot be combined with a temporary buydown. Rocket Mortgage may modify product eligibility and criteria at any time. Additional conditions apply. This is not a commitment to lend.

Refinancing may increase finance charges over the life of the loan.

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