Buydown: A way to reduce interest rates

It’s no secret that buying 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 interest and applicable fees.

While it might seem like you can only hope that interest rates are low, there is a strategy to help ensure your mortgage payments are more manageable in the future, despite predicted trends and rate hikes. By paying more money upfront, you can score a lower interest rate on your mortgage.

This financing technique is called a buydown, or buying down your interest rate. Learn how a buydown works and whether it’s the right move for you.

What is a buydown on a mortgage?

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. In the case of discount points, the interest rate is lower for the loan term.

Think of a buydown as a way of buying down your interest rate for your mortgage.

Or, your interest rate is initially lower, then will increase each year back to its initial rate. Some sellers, lenders or homebuilders may go this route to attract home buyers.

Buying down interest rates can be a useful tactic to protect yourself against paying more in interest throughout the life of your loan.

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

The cost for each discount point typically equals 1% of your loan amount and lowers your interest rate by .25% For example, if you take out a mortgage for $400,000 and you’re initially offered an interest rate of 4%, paying $4,000 would lower your interest rate to 3.75%.

Who can buy down a mortgage?

Although it’s the home buyer who benefits from a buydown, the buyer isn’t always the one who buys down the interest rate. Sellers and builders can also purchase points.

Buyers

Most buydowns are negotiated between buyers and mortgage lenders, where the buyer pays points for a lower interest rate. Doing so could make the mortgage more affordable for a certain number of years or over the loan term, depending on the buydown structure.

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 or pay for points over the entire loan term as part of seller concessions.

However, to make up for this expense 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 makes 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.

Lenders

Lenders may also offer rate buydowns as a special deal, either as a temporary buydown in effect at the beginning of the term or over the life of the term.

How buydowns are structured

Since buydowns are negotiated, they can be arranged in many ways. In addition to buydowns over the life of the loan, common structures of temporary buydowns lenders use are the 1-0 buydown and the 2-1 buydown. A 3-2-1 buydown is less common. 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. Not all buydowns expire. If one 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.

1-0 buydown

With a temporary 1-0 buydown, your interest rate is 1% lower than what your contract rate would be for the rest of the loan for the first year.

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 at the permanent rate by the third year.

In a 2-1 buydown, the rate is 2% lower in the first year, 1% lower in the second, and then set for the rest of the loan. If you take advantage of this option, you would be looking at the following payment structure and savings with the sample loan above:

3-2-1 buydown

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

As an example, a home buyer wants to borrow $300,000 and qualifies for a 30-year fully amortized mortgage 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% the first year, 5% the second year and 6% the third year. Afterward, the rate would go back to the full 7%.

The chart below shows how the buydown would affect the buyer’s monthly mortgage payments:

While the number of points charged for the buydown differs among 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 $13,756.

Evenly distributed interest rate reductions

A buyer may choose to purchase enough discount points to reduce their interest rate evenly over the life of the loan. This means the buyer pays an even larger sum upfront that prevents their interest rate from increasing.

Using the same example as above, the buyer would be expected to pay a monthly mortgage payment of $1,995.91 for 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:

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.

The amount you save on interest depends on the type of mortgage you borrow. 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 offers to pay the discount points on behalf of the buyer without significantly increasing the purchase price of the home. If the buyer intends to pay the points themselves, there are certain circumstances in which mortgage buydowns are more suitable.

When you should use a buydown

You must have enough savings to afford to pay for a down payment and closing costs and still have a significant amount of 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 for a graduate student who believes their income will double after receiving their degree. Buying down the interest rate for a mortgage would also make sense if a stay-at-home parent were 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 in question 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)

Example of calculating breakeven point

If you’re looking to obtain a 30-year, $300,000 mortgage with an interest rate of 7%, and your lender charges you four 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 $1,995.91 to $1,798.65. Therefore, your monthly savings would be $197.26.

$12,000 divided by $197.26 comes to 60.83, so 61 months is the breakeven point. That means it would take you about 5 years and a month 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 61-month 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.

Pros and cons of buying down a mortgage rate

As with any step you take during the home buying process, it’s important to carefully consider both the benefits and drawbacks of interest rate buydowns.

Pros of buydowns

• 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.
• Increased cash-flow: Since your monthly payments will be smaller, more of your monthly income will be free 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 could save money.

Cons of buydowns

• Large upfront cost: Paying to buy down your rate requires paying more cash upfront, which can add to your closing costs.
• May not result in savings: If you sell the house before the breakeven point, the monthly savings will not be worth the upfront cost.
• Eventual larger monthly payments: Most rate buydowns are temporary. Some borrowers may not be prepared when the discounted rate period ends and their monthly payments go up. They could end up struggling to make the increased payments.

Limits to buying down interest rates

Buydowns are typically only eligible when purchasing or refinancing primary residences and second homes. Borrowers need to be able to qualify for the standard interest rate of the zero-point loan to be able to buy down a home loan.

Investment properties

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

Mortgage type

Adjustable-rate mortgages (ARMs) are generally only eligible for plans that have an initial interest rate period of at least 3 years.

State-specific regulations

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

Government-backed programs

The bottom line: Buydowns can save buyers cash

Mortgage buydowns enable buyers to lower their monthly mortgage payments either permanently or 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, buying down interest rates isn’t a good fit for all home buyers. If you’re interested in this strategy, 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.