How to Buy Down a Mortgage

Mortgage buydowns can reduce your monthly payments

Row of identical homes
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For many borrowers, a mortgage buydown can be more advantageous than an adjustable loan with a payment option that allows for negative amortization like an option ARM. Mortgage buydowns always include principal and interest in the consumers' monthly payments. This means every time homeowners make mortgage payments, their loan balances grow smaller instead of bigger. A smaller mortgage balance means that equity is growing, even when appreciation is low.

Common Mortgage Buydown Features

Mortgage buydowns work like this:

  • Payments are reduced and figured 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 by the seller or the buyer.
  • Think of it like a subsidy. It's like socking away $1200 in the bank and withdrawing $100 every month for 12 months to help make your mortgage payment.

3-2-1 Mortgage Buydown

For example, say your loan balance is $350,000 and the interest rate is fixed at 6.75 percent for 30 years. The seller (or you) could "buy down" the interest rate by paying a lump sum of $15,853. This is how it works:

  1. The first year's interest rate is 3.75 percent payable at $1,621 per month.
  1. The second year's interest rate is 4.75 percent payable at $1,826 per month.
  2. The third year's interest rate is 5.75 percent payable at $2,043 per month.
  3. Years four through 30 carry an interest rate of 6.75 percent payable at $2,270 per month.

As a result:

  • The first year's savings (as compared to $2,270 per month) is $649 per month or $7,790.
  • The second year's savings (as compared to $2,270 per month) is $444 per month or $6,332.
  • The third year's savings (as compared to $2,270 per month) is $228 per month or $2,731.

Add up the annual savings: $7,790 + $6,332 + $2,731 = $15,853. Therefore, it costs $15,853 to buy down the interest rate and payments for three full years.

3-2-1 Mortgage Buydown Benefits

  • The borrower qualifies for this loan at the 3.75 percent interest rate and payment amount of $1,670 versus the real rate of 6.75 percent and the payment of $2,270.
  • Instead of the payment jumping all at once, it goes up in smaller increments, about $200 each year, for the first three years.
  • It keeps payments low for 36 months for borrowers whose income is expected to later increase. Perhaps a spouse is returning to work after a hiatus or a person expects to graduate and land a higher paying job with that newly earned degree.

2-1 Buydown Mortgage

  • This is a 30-year fully amortized mortgage.
  • The interest rate increases 1 percent every year for the first two years.
  • Then the interest rate is fixed for the remaining term.

For example, say your loan balance is $350,000 and the interest rate is fixed at 6.75 percent for 30 years. The seller (or you) could "buy down" the interest rate by paying a lump sum of $8,063.

This is how it works:

  1. The first year's interest rate is 4.75 percent payable at $1,826 per month.
  2. The second year's interest rate is 5.75 percent payable at $2,043 per month.
  3. Years three through 30 carry an interest rate of 6.75 percent payable at $2,270 per month.

As a result:

  • The first year's savings (as compared to $2,270 per month) is $444 per month or $6,332.
  • The second year's savings (as compared to $2,270 per month) is $228 per month or $2,731.

Add up the annual savings: $6,332 + $2,731 = $8,063. Therefore, it costs $8,063 to buy down the interest rate and payments for two full years.

Permanent Mortgage Buydowns

A permanent mortgage buydown occurs when your buy down the interest rate at inception through paying loan points. Most buyers do not want to take money out of pocket to buy down a rate, but sometimes it makes sense.

Also, suppose the seller is paying a closing cost credit of 4 percent to the buyer, and the buyer's closing costs amount to 2 percent. Use the extra 2 percent credit to buy down the interest rate!

Note: Lenders typically require a higher down payment for a 3-2-1 Buydown and a less for a 2-1 Buydown. There are other types of mortgage of mortgage buydowns, but these two are the most popular. 

At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.