A new home is one of the most expensive and important investments you’ll ever make. When you get a mortgage, you’re not only paying the purchase price of the home. You’ll also pay interest each month for the privilege of borrowing that money. It’s no secret that mortgage interest rates are on the rise, but that doesn’t mean your payments are destined to be unmanageable for the foreseeable future. By paying more on your mortgage up-front, you can help secure a lower interest rate, despite what the news and trends might tell you. How does a mortgage rate buydown work? Today, we’re sharing everything you need to know to get started.
How Does a Mortgage Rate Buydown Work?
A mortgage buydown allows borrowers to secure a lower interest rate by paying what’s known as “discount points” at their closing. Also called mortgage points or prepaid interest points, these points are a one-time fee that home buyers pay up-front. By doing so, you can achieve a lower interest rate for your loan term.
There are a few different ways that buydown programs can be structured, though the basic principles remain the same. Let’s take a look at the most common ones.
3-2-1 Buydowns
In a 3-2-1 buydown, the home buyer will pay less interest on their mortgage for three years after they obtain their loan. They’ll pay the points up-front, which reduces the interest rate by 1% for each year. The most significant savings will occur in the first year and taper from there.
For example, say a borrower qualifies for a 30-year, fully amortized mortgage at an interest rate of 5%. If they pursue a 3-2-1 buydown, then they’ll pay an interest rate of 2% in the first year, 3% in the second year, and 4% in the third year. By the fourth year, they’ll be back to paying the full 5% and will continue with that rate for the rest of the 30 years.
2-1 Buydowns
A 2-1 buydown works similarly to a 3-2-1 buydown, but only offers savings for the first two years of the loan term. With this program, the buyer’s interest rate lowers by 2% in the first year and 1% in the second.
Using the same example as above, the borrower’s interest rate would be 3% in the first year and 4% in the second year. For the rest of the term, it would be the standard 5%.
Permanent, Evenly Distributed Buydowns
While 3-2-1 and 2-1 buydowns can help offset the costs of your interest rate in the first few years of your mortgage, they won’t provide any relief for the remaining majority of the term.
That’s why some borrowers opt for evenly distributed buydown programs. With this approach, they’ll choose to purchase enough discount points during the closing to reduce their interest rate by an even amount throughout the life of the loan. This is usually called a buydown loan.
As you might expect, these programs require a larger up-front investment. However, once you pay that one lump sum, you can lock in your lower interest rate. This prevents your monthly mortgage payments from ever going up, no matter how market conditions fluctuate.
These can be beneficial, but only if you plan to stay in your home for at least five years. If you know the home will be short-term, then a 3-2-1 or 2-1 buydown program will offer more significant savings.
What Does It Cost to Buy Down Your Mortgage?
The cost for each discount point will vary by borrower. It ultimately depends on how much you take out for your loan. Each point you pay will be equal to 1% of your total loan amount. Your lender will be able to provide you with all of the options that you qualify for and can explain how much you can expect to receive in savings.
For instance, say your lender offers you the opportunity to purchase one point, effectively reducing your interest rate by 0.25%. If you’re obtaining a mortgage for $500,000 and your current interest rate is 5%, then you can pay $5,000 (1% of $500,000) to lower the rate to 4.75%.
Which Parties Can Buy Down a Mortgage?
Most of the time, home buyers are the ones who choose to buy down their mortgage. To do so, they’ll negotiate the agreement directly with their lender. In this case, you’ll pay your discount points up-front and receive a lower interest rate in return.
Yet, buyers aren’t the only ones who can arrange a buydown program. Sellers and builders can pursue these opportunities, too. Let’s see how.
Sellers
If a seller is highly motivated, they may offer to buy down a buyer’s mortgage as an incentive to encourage them to purchase the home. When this happens, the seller will usually make a one-time payment (also called a subsidy) that’s deposited into a special escrow account to be used for a designated period of time. Or, they may choose to pay for points that apply throughout the entire loan term.
This agreement will be listed as part of the seller’s concessions. When lenders receive this payment, they can use the money to lower the buyer’s interest rate. This helps the buyer afford the home loan more easily.
While this can be an attractive offer, pay attention to the fine print. If it’s a seller’s market, the seller will often incorporate the cost of the subsidy into the purchase price of the property. If that’s the case, you aren’t truly saving any money. You’re simply paying for the discount points as part of the total purchase.
The most attractive type of buydown is when a seller offers to pay the points on behalf of the buyer without substantially raising the purchase price of the property.
Builders
Similar to sellers, builders can also offer to pay discount points to buy down a buyer’s mortgage, though this arrangement isn’t as common. When it happens, it’s usually to encourage prospective buyers to purchase a plot or property in a builder’s newly-built neighborhood or development.
Over time, as those communities become more established, builders will offer this deal less frequently. If you can get in with a builder or developer in the early stages of the planning phase, you may be able to take advantage of this type of setup.
The Pros of Buying Down Your Mortgage
There are many advantages to buying down your mortgage. Let’s take a look.
Lower Interest Rate
The main benefit of a mortgage rate buydown program is the lower interest rate you can enjoy, if even for those initial few years. If you opt for a permanent program, you can even enjoy those savings over the life of your loan.
Potential Tax Write-Off
While there is a cost associated with purchasing the discount points, you may be able to write down those costs on your taxes. Your lender will be able to advise you on whether that step is applicable in your situation.
Higher Loan Amount
If you know that you want to participate in a mortgage rate buydown program, then let your lender know as soon as possible. You may be able to qualify for a higher loan amount due to the lower, more affordable interest rate that it carries.
The Cons of Buying Down Your Mortgage
While securing a lower rate might sound appealing, it’s important to understand the flip side of the coin. Here are a few potential cons to keep in mind if you’re considering buying down your mortgage.
Higher Closing Costs
You’ll be required to pay your discount points at closing. Thus, this means that you can expect your total closing costs to be higher than they would be if you weren’t pursuing a buydown program.
Not Always Permanent
In the case of a 3-2-1 or 2-1 buydown program, the reduced price on your interest rate isn’t permanent. Unless you lock in a permanent agreement, it will raise back up once the term is over.
If you purchase your home based on the lower interest rate, you might find it impossible to pay your full monthly mortgage when that rate returns to its original state. If this happens, you run the risk of depleting your savings or even entering into foreclosure. Always make sure you can afford the standard interest rate, even if you do decide to lower it for a few years through a buydown solution.
Ensure you have enough cash savings to pay for a down payment and closing costs, with a solid amount of money left over. If you can confidently say that you do, then you may benefit from the lower payments that a buydown program can provide in the first few years.
Should You Pursue a Mortgage Rate Buydown Program?
A mortgage rate buydown can offer significant savings to potential home buyers. Yet, it’s important to know what you’re agreeing to.
Before signing on the dotted line, make sure you understand all of the terms and details. Often, if an outside party agrees to pay your discount points, you’ll be required to absorb those costs through a higher purchase price.
Looking to put down roots in or around Raleigh, NC? If so, we’ll help you find the property of your dreams, at a price you can afford. Take a look at our available homes today!
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