Are you wondering, “Can I afford to buy a home?” Well, there are a few ways that savvy buyers can address rising interest rates and a mortgage buydown is one of them.
Here’s what you should know about mortgage buydown and if it’s right for you.
Hint — it’s not right for everyone!
1. What is a mortgage buydown?
A mortgage buydown is when a borrower pays more money upfront to secure a more manageable and lower interest rate for the first few years of their mortgage.
If the buyer/borrower chooses to go this route, they’ll pay an additional charge at closing known as “discount points” or “mortgage points.”
This is a form of prepaid interest.
Mortgage points are like having a store membership card.
You pay a fee upfront to obtain a discounted price in the long run.
2. How does a mortgage buydown work?
As noted above, the process of mortgage buydown involves buying discount points at closing to prepay mortgage interest.
You can purchase these mortgage points when you’re either buying a home or refinancing your mortgage.
Doing so can help you reduce your rate and monthly payment.
3. How much is a discount point worth?
Discount points can seem really vague when you’re first learning about mortgage buydown.
Here’s how you can quantify this.
Each discount point will cost 1 percent of your loan amount.
So, if you purchase one point on your loan of $500,000, then it’ll cost you $5,000 upfront.
That said, the rate drop isn’t necessarily 1:1.
Your lender will determine how much your rate is reduced per point purchased.
So, your lender may decide that buying one point could lower your interest rate by 0.5 percent or 0.375 percent rather than a full 1 percent.
We recommend shopping around with different lenders.
This will allow you to compare rates and buydown options
Additionally, you’ll need to ask whether your rate reduction is temporary or permanent.
We’ll talk about the types of buydown structures in the next section.
4. What is a temporary mortgage buydown versus a permanent mortgage buydown?
We’ll talk more about the specific structures of mortgage buydowns in the next section.
However, before you negotiate a specific structure according to your interest rate, you should know the core difference between temporary and permanent buydowns.
Temporary Mortgage Rate Buydown
If you go this route, you pay a lump sum to your lender.
It reduces your interest temporarily for just the first year(s) of your loan.
You’ll ease into the full mortgage payment at the beginning of the loan term, and then it’ll ramp up and return to normal.
Here’s how it’ll typically work.
Both you and your lender will…
- Review investor pricing sheets
- Select the best option that fits your needs
Then, you’ll…
- Pay a lump sum (the buydown) to your lender at closing
You’ll pay this lump sum in addition to any closing costs that you owe.
Because you’ve paid this, your monthly payments will be lower than they would be without a temporary/permanent mortgage buydown.
This is because you’ve secured a lower interest rate for those first few years.
Your interest rate will then go back up.
Permanent Mortgage Rate Buydown
This type of buydown can be used to help a buyer lower the interest rate on their mortgage.
The lump sum is paid to the lender at closing, and the buyer will take possession of the home with an interest rate lower than shown on the note.
That said, they’ll need to make additional principal payments over time to pay off the mortgage at its original terms.
Here’s what you should consider when it comes to a permanent mortgage buydown:
- Discount points are paid to the lender in exchange for a lower rate
- The more mortgage percentage points you buy, the lower rate you’ll get
- The interest rate won’t change for the duration of the loan unless you get an ARM (adjustable-rate mortgage)
5. What are the three types of mortgage buydown structures?
There are three different types of mortgage buydown structures, and you’ll need to determine which (if any) is right for you before you move forward.
Permanent Rate Reduction
If you’re able to obtain this type of buydown, then the interest rate discount will extend over the life of your loan.
It’ll give you a lower monthly payment during the entire payment schedule.
3-2-1 Buydown
This is a temporary reduction that allows you to get an interest rate that starts low and increases incrementally for the first three years.
As the name suggests, the interest rate will be 3 percent lower in the first year.
In the second year, it’ll be 2 percent lower, and finally, in the third year, it’ll be 1 percent lower.
After that, in the fourth year and onward, the interest rate will bump up to the standard rate.
So, if your standard rate is 6 percent, then it would be 3 percent your first year, 4 percent your second year, and 5 percent your third year.
All the following years it would be 6 percent.
If you have a 3-2-1 Buydown, all the extra you pay during the buydown period goes into an account.
Each month, the amount equal to your interest rate reduction is deducted from that amount and applied toward your payments.
You’ll still end up paying the same for the mortgage as you would without the buydown.
2-1 Buydown
With this model, you can reduce your interest rate by 1 percent the first year and 1 percent the second.
During the third year, your interest rate increases and stays the same for the rest of the loan term.
At closing, funds are collected, and they go into an escrow account that’s deducted from each month.
Just like 3-2-1 Buydown, you’ll still pay the full amount for the mortgage (including the interest) just like you would if you hadn’t paid into the account upfront.
6. What are the pros of a mortgage buydown?
Are you wondering why some people opt for a mortgage buydown?
Here are the advantages:
It reduces your monthly costs
If you obtain a lower interest rate, it can help you lower your monthly mortgage payment.
Who wouldn’t want to have a little bit of extra money each month to use on other long-term expenses or financial goals?
However, you do need to check whether you’re obtaining a permanent or temporary mortgage buydown.
As noted above, some structures like the 3-2-1 and 2-1 Buydown will still have you paying the same amount of money overall.
It saves you money in the long term
Having a permanently lower rate can help you save thousands of dollars over a traditional 30-year mortgage.
For instance, if you secure a rate of 6 percent instead of 7 percent on a $400,000 home loan, you can save almost $95,000 in interest over 30 years.
That’s nearly ¼ of the original price!
That said, should interest rates go down and you refinance to the lower rate, you will essentially waste the points you bought.
Also keep in mind that with a temporary buydown, you’ll still pay the same amount overall, which means there wouldn’t be many benefits unless the lender or seller pays for it.
It can help you qualify for a tax deduction
Buying points is prepaying mortgage interest.
So, points purchased can be eligible for the home mortgage interest deduction.
Understanding this in advance and knowing how you can qualify for tax deductions can save you money overall!
It can help you ease into higher payments
For some people, the temporary structure of a mortgage buydown is just what they need to get started.
They’re at the beginning of their career, and they expect to see their income rise.
They don’t anticipate having any issues with making higher mortgage payments over time, but right now, they think that having lower payments while some of their other expenses are high could be helpful.
7. What are the cons of a mortgage buydown?
As we noted at the beginning of the article, mortgage buydowns don’t make sense for every buyer.
This may not be the right route for you. Don’t just look at the advantages, check the following disadvantages as well.
It’s expensive
Buying a home is expensive.
When asked to come up with additional cash to buy mortgage points, many buyers aren’t able to do it.
This may not be the right route for you simply because you don’t have the liquidity.
It may not be cost-effective
If you’re planning to resell or refinance this home in just a few years, you may not want to go the mortgage buydown route.
Sometimes you won’t see enough interest savings from buying mortgage points to make a big difference.
It’s temporary
As noted above, not all mortgage buydown structures are permanent.
Many of them are temporary which means you’ll end up paying the same amount overall.
It may be nice to have a little extra cash temporarily, but the high-interest rate will catch up with you sooner or later.
You need to evaluate whether it’s something you can afford.
It’s not always available
Not everyone is in a position to take advantage of a mortgage buydown.
The availability of these structures is often limited by the type of property involved or the type of mortgage loan for which you’re applying.
It’s worth asking if you think you’re a good candidate, but you shouldn’t expect that it’ll be available.
It can put you at risk of default
Be wary of going with a mortgage buydown program depending on your financial status.
If you’re not able to make higher payments after the initial buydown period, then you can lose your home to foreclosure.
This isn’t worth it!
You must consider all the costs involved and remember to only purchase a home that you can afford.
8. Who benefits from a mortgage buydown?
We listed the pros of a mortgage buydown from a buyer’s perspective above, but did you know that the seller benefits from this route as well?
When a seller offers this option, they can often achieve a higher sales price.
So, in addition to the buyer getting a lower interest rate and monthly rate (either temporarily or permanently), the seller can get more money overall because the buyer can afford more.
9. What’s the difference between a mortgage buydown and an adjustable-rate mortgage?
The primary difference between these two types of loans is the interest rate.
The interest rate and monthly payment of the adjustable-rate mortgage are subject to periodic change throughout the loan term.
On the other hand, with a mortgage buydown, the seller (and sometimes the lender) pays part of the borrower’s interest payment for the year(s) of the loan.
However, the underlying note rate stays consistent.
So, the interest rate doesn’t fluctuate with market conditions with a buydown mortgage, unlike ARM.
10. Is it worth it?
So, when does a mortgage buydown make sense?
There are a few scenarios in which people should seriously consider this route.
The first is when it allows them to get a mortgage without significant financial impact.
What does that mean?
It shouldn’t drastically increase the purchase price of the home or drain their cash reserves.
Additionally, for people who have a stable income that will likely increase over the life of the loan, then this can also be a green flag.
They are more likely to be able to make payments without issue.
Furthermore, if you’re a home buyer looking for your forever home (or at least a home that you’ll own for a long time), then it could also make sense for you to go this route.
The longer you own your home, the more likely it’ll be that you see the full benefit of interest savings after buying discount points.
When you sell a home too soon, you’re unlikely to break even.
You won’t get to the point where the money saved from the lower interest rates surpasses the cost of buying points.
Take the following example.
You buy a home with a loan amount of $400,000.
You buy one mortgage point for $4,000.
This prompts your interest rate to drop from 6.75 to 6.25 percent.
This means you’re saving $132 each month, and it would take about 30 months (2.5 years) to see a return of that $4,000 that you paid for the discount point.
If you were planning to relocate, downsize, upsize, etc. before the two-month mark, then it may not make sense for you to do a mortgage buydown.
Also, keep in mind that if interest rates go down before the 30 month mark, you will lose the value of the points you bought when you refinance to a lower rate.
Final Thoughts
Mortgage buydown can be one option for homebuyers who are looking for a reprieve from high-interest rates.
That said, this route requires funds that can be expensive in addition to a down payment and closing costs.
If you’re not sure if you’re financially capable of doing this, then there are other ways you can lower your rate.
Moreover, buyers who are looking to make a shorter-term home purchase for just a couple of years may not benefit from a mortgage buydown financially.
Make sure you weigh all the pros and cons for your specific situation before you opt for this route.
Additional Resources
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.