Buyers looking to finance the purchase of a home amid higher interest rates and rising prices are looking closely at something known as a “mortgage buydown.” It’s a creative way to trim mortgage payments in the early months of homeownership, an option that grew in popularity late in 2022 when interest rates more than doubled from the start of the year.
What exactly is a mortgage buydown? It’s a financial tool offered by some lenders that lowers the interest rate charged on the mortgage. This helps buyers reduce the monthly payment for a year or so in anticipation of having more income in future years to begin paying off the mortgage at the full interest rate established at the time of purchase.
The lender charges an upfront fee to buyers to “buy down” the interest rate for a set amount of time, usually two or three years. This is also known as a temporary buydown. The other option is for a borrower to pay a lump sum upfront for the lender to permanently reduce the interest rate, also known as buying points (more on that later).
The most common form of this mortgage option in our area appears to be a so-called 2-1 buydown. That allows the borrower to pay a fee that reduces the mortgage rate in the first year by two percentage points and by one point in the second. The prevailing rate of today would begin in the third year, at which time some borrowers may refinance their mortgage (assuming the available interest rate is at least one percentage point lower than at the start of the financing period) or they can bite the bullet and pay the full rate for a while longer.
A so-called 3-2-1 buydown is also available from some lenders. That’s when borrowers pay an upfront fee to reduce the first-year interest rate by three percentage points, the second year by two points and third year by one.
Buydowns are somewhat like “buying points,” another method to reducing the interest rate on a loan and they are typically locked in for the full term. A “point” usually equates to one-quarter of a percent, not a full percent (1.0%), and it allows buyers to enjoy the same lower rate through the life of the loan.
The buydown fee is essentially helping to pay off the higher interest and the cost can vary widely, but research shows the amount comes to about 2.3% of the purchase price. That can be a substantial figure due at closing on top of traditional fees and the down payment. You can find buydown calculators (example) to help better understand the costs.
In all cases, buyers must qualify for the mortgage based on the current interest rate – not a discounted figure. Nor can buyers qualify for a larger loan based on the lower buydown rate.
In a buyer’s market, it’s common to see sellers contribute a portion of their net proceeds from the sale toward the buydown. That is known as a third-party contribution and a great way to market the sale of the home. Sellers tend to prefer making a contribution to buyers rather than reduce the offer price.
Plus, if sellers itemize their federal tax filing for the year of the transaction, they can deduct the buydown against their capital gain. Sellers should have their tax accountant review IRS Publication 936.
Admittedly, buydowns are not typically a tool used by owners to sell a home in Seattle/King County unless the property is in poor shape and there is a sense of urgency to unload the property. Buyer demand is still strong in the second half of 2023 even while mortgage rates remain stubbornly high, reducing the incentive for sellers to offer “free money” in the form of a buydown.
One of the risks to buyers is that they are anticipating greater financial resources – a pay boost, second job or investment gains – to help cover the bigger mortgage outlay when the buydown period ends. The hope is that new mortgage holders keep their eye on the goal of being able to afford the mortgage payments years later and not spend the potential savings on extravagances.
The idea of using a buydown is to get into a home as soon as it becomes an affordable proposition. It allows buyers to start building equity as opposed to spending more years renting a place and watching housing prices appreciate.
Borrowers can also save through a buydown if they plan to sell the home within the first 3-5 years of ownership. That’s because they are paying a reduced interest rate, with a lower monthly outlay, and are on the hook for less interest paid on the loan.
Buydowns are one of many mortgage choices in a large tool chest of options for lenders and buyers. Work with a trusted loan consultant, accountant and real estate broker to ensure all tools are made available.
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