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Buydown: A Way To Reduce Interest Rates

Rachel Burris7-minute read

August 20, 2020

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It’s no secret that purchasing a house is an expensive undertaking. When you get a mortgage, you’re not only committing to paying the purchase price of the home – you’re also agreeing to pay for the privilege of borrowing money.

While you can pray that interest rates are low at the time you’re ready to obtain a loan, there’s actually something you can do to ensure your mortgage payments are more manageable in the future. By paying more money upfront, you can score a lower interest rate on your mortgage.

This financing technique is called a mortgage buydown. Read this article to learn what a buydown is, how it works and whether it’s right for you.

What Is A Buydown?

A buydown is a way for a borrower to obtain a lower interest rate by paying discount points at closing. Discount points, also referred to as mortgage points or prepaid interest points, are a one-time fee paid upfront. Each point that a borrower pays is equivalent to 1% of the loan amount.

For example, a mortgage lender may offer a borrower the ability to reduce their interest rate by .25% in exchange for a point. So, if the borrower is obtaining a mortgage for $400,000 and is offered an interest rate of 4%, paying $4,000 would lower their interest rate to 3.75%.

Typically, the points purchased reduce the interest rate for the first few years of the loan. Since the interest rate is lower during this time, the borrower’s monthly mortgage payments are more affordable.

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Who Can Buy Down A Mortgage?

Although it’s the buyer (or borrower) who benefits from a buydown, the buyer isn’t always the one who buys down a mortgage. Sellers and builders can also be responsible for purchasing points to lower the buyer’s interest rate. 

Buyers

The majority of buydowns are negotiated between buyers and lenders. Buyers offer to pay a specific number of points upfront, and in return, they receive a lower interest rate, making their mortgage more affordable for a certain number of years.

Sellers

Sellers may also offer to buy down a buyer’s mortgage to incentivize the buyer to purchase their home. In these circumstances, the seller will make the one-time payment and deposit it into an escrow account.

This payment, or subsidy, provides the lender with the funds necessary to lower the buyer’s interest rate so that the buyer can more easily afford their mortgage. However, to make up for this expense, especially in a seller’s market, the seller often will add the cost of the subsidy to the purchase price of their home.

Builders

Like sellers, builders may also offer to pay points to buy down buyers’ mortgages. Typically, a builder will make these upfront payments to entice early buyers to purchase properties in their newly built communities. Once their communities are established, builders are usually less inclined to offer this kind of incentive. 

How Buydowns Are Structured

Since buydowns are negotiated, they can be arranged in a variety of ways. The most common structures that lenders use are the 3-2-1 buydown and the 2-1 buydown. However, regardless of the structure, the principles are the same.

The buyer, seller or builder will pay the lender the difference between the standard interest rate and the lowered rate through points at closing. The buyer will benefit from the reduced interest rate until the buydown expires, usually after a few years. Once it does, the buyer will have to pay the standard interest rate for the remainder of the term, which will cause their monthly mortgage payments to increase. 

3-2-1 Buydowns

A 3-2-1 buydown enables a buyer to pay less interest on their mortgage for 3 years after obtaining the loan. The points paid upfront reduce the interest rate by 1% for each of those first 3 years.

Let’s say a buyer wants to borrow $400,000 and qualifies for a 30-year fully amortized mortgage at an interest rate of 5%. The buyer decides they want to lower their interest rate for the first 3 years with a 3-2-1 buydown. In this scenario, the buyer would pay an interest rate of 2% the first year, 3% the second year and 4% the third year but would have to pay the full 5% from years 4 – 30.

Review the chart below to see how the buydown would affect the buyer’s monthly mortgage payments.

 

Year

Interest Rate

Monthly Payment

Monthly Savings

Annual Savings

1

2%

$1,478.48

$668.81

$8,025.70

2

3%

$1,686.42

$460.87

$5,530.44

3

4%

$1,909.66

$237.63

$2,851.50

4 – 30

5%

$2,147.29

$0

$0

 

While the number of points charged for the buydown differs between lenders, the cost of the buydown is usually roughly equal to the amount the buyer would save in interest. In this case, the total cost of the buydown would be around $16,400. 

2-1 Buydown

A 2-1 buydown also provides a buyer with a discounted interest rate but only for the first 2 years of the loan’s term. With this option, the interest rate would be 2% lower the first year and 1% lower the second.

Based on the previous example of a $400,000 30-year loan with a standard interest rate of 5%, the buyer would be expected to pay an interest rate of 3% the first year, 4% the second year and 5% from years 3 – 30.

 

Year

Interest Rate

Monthly Payment

Monthly Savings

Annual Savings

1

3%

$1,686.42

$460.87

$5,530.44

2

4%

$1,909.66

$237.63

$2,851.50

3 – 30

5%

$2,147.29

$0

$0

 

The buyer would save approximately $8,380 in interest, so the buyer should expect the total cost of the 2-1 buydown to be in that same ballpark.

Evenly Distributed Interest Rate Reductions

In some circumstances, a buyer may choose to purchase enough discount points to reduce their interest rate evenly over the life of the loan. By obtaining a buydown loan, the buyer pays an even larger sum upfront that prevents their interest rate and thus their monthly mortgage payments from ever increasing.

Using the same example as above, the buyer would be expected to pay a monthly mortgage payment of $2,147.29 for a zero-point loan, which is a loan without any discount points applied. If the buyer decides they’d rather buy down the mortgage and pay 4% interest throughout the loan’s term, their payments would look like this:

 

Year

Interest Rate

Monthly Payment

Monthly Savings

Annual Savings

1 – 30

4%

$1,909.66

$237.63

$2,851.50

 

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 significantly higher. It would cost the buyer somewhere around $85,550.

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When Does A Buydown Make Sense?

Buydowns are most beneficial when a seller or builder offers to pay the discount points on behalf of the buyer without significantly increasing the purchase price of the home. However, if the buyer intends to pay the points themselves, there are certain circumstances in which mortgage buydowns are more suitable.

To begin, the buyer must have enough savings that they can afford to pay for a down payment and closing costs and still have a significant amount of cash left over. If that’s the case, having lower payments in the first few years may be beneficial if they expect their income to be considerably higher in the future.

For example, a buydown may make sense for a graduate student who believes their income will double after receiving their degree. Buying down a mortgage would also make sense if a stay-at-home parent was planning to return to work a couple of years after obtaining their loan.

But keep in mind that buydowns are all about paying more money upfront so you can save money in the long run. Therefore, buydowns only really make sense if the buyer intends to own the home for an extended period of time.

The Breakeven Point

To determine if a buydown is worthwhile, you must calculate the breakeven point. The breakeven point is the amount of time it’ll take to recoup the cost of the discount points required to lower your interest rate. To do the calculation, you divide the cost of the discount points by the monthly savings.

Breakeven Point = (The Cost Of Points) / (Monthly Savings)

Let’s take a look at a simplified example of how this would work. If you’re looking to obtain a 30-year, $400,000 mortgage with an interest rate of 5%, 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 $20,000. By paying 4% in interest instead of the standard 5%, your mortgage payments would drop from $2,147.29 to $1,909.66. Therefore, your monthly savings would be $237.63.

$20,000/$237.63 = 84.16, so 84 months is the break-even point. That means it would take you about 7 years to recoup the money you’d have to spend on discount points.

If you, as the buyer, think there’s a chance you’ll sell the home or refinance before the 7 year mark, a buydown wouldn’t make sense for you. Instead, you’d want to think about making extra payments, as you can also save money on interest by paying off your mortgage early.

Are There Limits On Buydowns?

If you’re interested in a mortgage buydown, you should consult a lender as some restrictions apply. Buydowns are only eligible when purchasing or refinancing principal residences and second homes. Typically, buyers must qualify for the standard interest rate of the zero-point loan to be able to buy down a mortgage.

Real estate transactions that involve investment properties or cash-out refinances are ineligible for buydowns. And adjustable rate mortgages (ARMs)are generally only eligible for plans that possess an initial interest rate period of at least 3 years.

Some states put limits on seller subsidies to prevent home prices from becoming overly inflated. Thus, in some areas of the country, there’s a limit on how many points a seller or a builder can purchase on behalf of a buyer.

There are also restrictions when it comes to federally funded programs. For example, with FHA loans, buydowns are only permitted on fixed-rate mortgages used to purchase homes. This means FHA borrowers cannot buy down mortgages if they’re refinancing their home or obtaining an ARM mortgage.

Summary: Buydowns Can Save Buyers Cash

Generally speaking, mortgage buydowns enable buyers to lower their monthly mortgage payments in the first few years of their loan. By paying discount points at closing, buyers can reduce their interest rates slightly, which can lead to long-term savings.

However, buydowns are not appropriate for all buyers. If you’re interested in buying down your mortgage, you should calculate your breakeven point to ensure the amount of time it takes to recover the money spent on points is worth the upfront investment.

To learn more about financing a home, explore other articles on general mortgage topics and terms.

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Rachel Burris

Rachel Burris is a writer covering topics of interest to present and future homeowners, as well as industry insiders. Prior to joining Rocket Companies, she worked as an English teacher for the New York City Department of Education and a licensed real estate agent for Brown Harris Stevens. She holds a bachelor's degree in creative writing from Bucknell University, a postbaccalaureate certificate in psychology from Columbia University and a master's degree in English education from Teachers College, Columbia University.