How to Buy Down a Mortgage
Buying down a mortgage involves someone paying the lender an amount of money in exchange for a reduced interest rate during the first years of a mortgage, often an adjustable-rate mortgage (ARM). Buydowns can occur in other types of mortgages as well, however. They're not limited to ARMs.
Mortgage buydowns always include principal and interest in the consumers' monthly payments, so their loan balances grow smaller every time they make mortgage payments. A smaller mortgage balance means that equity is growing, even when appreciation is low.
Common Mortgage Buydown Features
Payments are reduced under a mortgage buydown because they're calculated on a lower interest rate over a specific term. The difference between the "real" note rate and the lowered interest rate is paid in cash in advance.
Think of it as a subsidy. It's like socking away $1,200 in the bank and withdrawing $100 every month for 12 months to help make your mortgage payment.
There's typically a fee involved, but it can be included in the loan amount when the buyer exercises this option.
The 3-2-1 Mortgage Buydown
One type of buydown is the 3-2-1 buydown:
- It's a 30-year fully amortized mortgage
- The interest rate increases 1% every year for the first three years
- The interest rate is fixed for the remaining term
For example, your loan balance might be $350,000 and the interest rate is fixed at 6.75% for 30 years. You or the seller could buy down the interest rate by paying a lump sum of $15,853.
- The first year's interest rate would be 3.75% payable at $1,621 per month
- The second year's interest rate would 4.75% payable at $1,826 per month
- The third year's interest rate would be 5.75% payable at $2,043 per month
- Years four through 30 would carry an interest rate of 6.75% payable at $2,270 per month
The first year's savings is $649 per month or $7,790, compared to $2,270 a month. The savings in the second year is $444 per month or $6,332, compared to $2,270 per month. The third year's savings is $228 per month or $2,731 compared to $2,270 per month.
Add up the annual savings: $7,790 + $6,332 + $2,731 = $15,853. It costs $15,853 to buy down the interest rate and payments for three full years.
The Benefit of a 3-2-1 Buydown
One benefit of this type of buydown is that the borrower can qualify for the loan at the 3.75% interest rate and the payment amount of $1,670 versus the real rate of 6.75% and the payment of $2,270. The payment goes up in smaller increments of about $200 each year for the first three years rather than jumping all at once.
This keeps payments low for 36 months, which can be handy for borrowers who expect that their incomes will increase later. Maybe a spouse will returning to work after a hiatus or someone expects to graduate and land a higher paying job with that newly-earned degree.
The 2-1 Mortgage Buydown
Another type of buydown is the 2-1 option. Here, the buyer has a 30-year fully amortized mortgage. The interest rate increases by 1% every year for the first two years, then the interest rate is fixed for the remaining term.
Say your loan balance is $350,000 and the interest rate is fixed at 6.75% for 30 years. You or the seller could "buy down" the interest rate by paying a lump sum of $8,063. This is how it works:
- The first year's interest rate is 4.75% payable at $1,826 per month
- The second year's interest rate is 5.75% payable at $2,043 per month
- Years three through 30 carry an interest rate of 6.75% payable at $2,270 per month
As a result, the first year's savings is $444 per month or $6,332, compared to $2,270 a month. In the second year, the savings is $228 per month or $2,731, compared to $2,270 a month.
When you add up the annual savings: $6,332 + $2,731 = $8,063, it costs $8,063 to buy down the interest rate and payments for two full years.
Lenders typically require a higher down payment for a 3-2-1 buydown and less for a 2-1 buydown. There are other types of mortgage buydowns, but these two are the most popular.
Permanent Mortgage Buydowns
A permanent mortgage buydown occurs when the buyer buys down the interest rate at inception through paying loan points, sometimes referred to as discount points.
Most buyers don't want to take money out of their pockets to buy down a rate, but it makes sense sometimes. The seller might pay a closing cost credit of 4% to the buyer, and the buyer's closing costs amount to 2%. They could use the extra 2% credit to buy down the interest rate.
Some Words of Caution
Although it's common for sellers to pay buydown points, buyers and builders can do so as well. Sellers often compensate by increasing the sales price of the property, however.
Buydowns can also be prohibited when you're buying through certain state or federal programs.