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What is A Mortgage Rate Buydown And How Does It Work?

In this volatile market, prospective homeowners are more worried than ever about affordability. With the threat of rising interest rates, forward-thinking sellers are getting creative when it comes to keeping their inventory competitive without losing out on too much profit. Savvy buyers are simultaneously looking for opportunities to take the edge off of these relatively higher rates, reducing their monthly housing payment, while still affording the home of their dreams. 

The idea of “buying down” a mortgage loan interest rate isn’t new, but it’s definitely gaining in popularity as a way for lenders to attract buyers by offering a lower monthly payment for either a certain amount of time or over the entire life of the loan.

What exactly is a mortgage rate buydown, and how can it work to your advantage? Let’s dig deeper. 

The Nuts and Bolts

There are two types of buydowns – temporary and permanent. Temporary buydowns will lower your interest rate for a year or two or even three, depending on the offer. After the designated buydown period, your payment will return to “standard”, reflecting the original mortgage note rate

This can be very tempting for some borrowers, especially as the first few years of home ownership can be the most expensive. It’s also a great opportunity to hedge one’s bets a bit. With interest rates higher now than in 2021 or early 2022, buyers are feeling a bit of shock at current rates. A temporary buydown can bridge the gap for a couple of years, while buyers anticipate being able to refinance to better rates a couple of years down the road, or their income expectations continue to grow.

A 2-1 Mortgage Rate Buydown Example

Who can benefit from a temporary mortgage rate buydown?

While all financed home buyers would love to benefit from lower mortgage rates, even if just for the first part of their mortgage, one important note is that buyers cannot finance their own buydowns. At least in most cases, the “investor” (the bank or portfolio manager who establishes the guidelines for the mortgage) will only permit the buydown to be funded by the seller (think: closing cost credit), the seller (think: home builder/developer), or other “interested party” (like a lender or listing brokerage offering an incentive.)

Are rate buydowns risky?

A borrower must qualify, based upon current stringent lending guidelines set forth by Fannie Mae and Freddie Mac, for a mortgage loan based upon the FULL “note rate”, or the full mortgage payment, as though there is no rate buydown. In this way, when the payment returns to “normal” 12 to 36 months down the road, the buyer will be making a mortgage payment they are qualified for, and their ability to repay has already been evaluated. 

Temporary buydowns reduce the buyer’s mortgage payment for the first one, two, or three years of the mortgage, but don’t technically change the mortgage note rate. In actuality, the party funding the buydown is providing a supplement to the mortgage payment. 

At closing, an escrow account is established, containing the funds, or the cost of the buydown. Each month the lender is recording a full mortgage payment against the mortgage, with a portion of it coming from the buyer/new owner, and a portion coming from that escrow account. 

At the conclusion of the buydown period, the funds in the escrow account will be exhausted, and the homeowner will now be making the full monthly payment. 

Is this an adjustable-rate mortgage (ARM)?

First-time home buyers might be confused by the differences between a temporary rate buydown and an adjustable-rate loan (ARM), the boogieman of the ‘06-’07 mortgage industry meltdown

While ARMs make a good deal of sense for homeowners who have confidence they will no longer have their mortgage in 5-10 years, they can carry some additional risk should the borrower hold their mortgage into the adjustable period of the loan. The upfront savings on an ARM should be weighed against the risk of substantially higher rates and payments down the road, should the buyer neither refinance nor move, in the interim. 

What is a Permanent Rate Buydown in mortgage terms? 

If you’ve heard the term “points”, or “discount points”, that is the same thing as a permanent buydown. 

A permanent rate buydown is a way to lower the interest rate from the start of your mortgage by purchasing “discount points” — an upfront fee that will save you quite a bit of money in the long run.

Generally speaking, “one point” equals one percent of the total loan amount, and points can be bought (or “sold”) in fractions ((½ point, ⅜ point, etc.) The more funds you have available to buy points (and pre-pay some of your interest), the lower your rates and monthly mortgage payments will be (with some limits.) 

By paying one percentage point of the total interest up front, borrowers can unlock a mortgage rate that’s more-or-less 0.25% lower

Sellers sometimes offer to pay for buydown points to make their property more enticing, but they might be tempted to compensate for this by raising the sales price. Your broker will be there every step of the way through the negotiation process to ensure you’re being treated fairly.

What’s Right for You

Before making any commitments or signing any paperwork, consult with your lender and real estate team. Every buyer’s situation is different, and you deserve an individualized approach to your specific mortgage needs. 

A permanent mortgage buydown is ideal for those that have the available financing at closing to purchase discount points, and who plan to stay in the home for a longer period of time. 

These funds could be from the buyer, seller, builder, or another interested party such as relatives or employers. A temporary buydown might make more sense, if a homeowner plans to refinance (or move) within a few years, anticipates that their income will increase in the near term, or simply wants to take the sting off of the cost of homeownership in its first couple of years. 

Some hopeful homeowners might wonder how buying points to lower the interest rate differs from simply making a larger down payment. Talk to me, or your trusted Key Mortgage loan officer, for an analysis on which approach makes the most sense, and at one point you’ll reach your breakeven point. 

Other considerations

Making a down payment of 20% used to be the norm, but there are now many loan products and programs that require much less. Down payments are applied to the total price of the property and help you build equity faster, while points work to reduce the interest rate on your loan. 

The calculations needed to determine which choice saves you the most money are somewhat complicated, and there are other factors involved. You may want to speak to a tax expert regarding deductions for these interest payments and how this move could affect your future obligations. 

Do you expect your credit score or income to increase within the coming years? This might make paying down your balance now and refinancing in the future a better fit for your financial plan.

Communicate with your lender regarding your plans and goals so you can benefit from their years of valuable experience and get a personalized quote, both with and without points.

The Bottom Line

Mortgage rate buydowns offer distinct advantages for certain consumers. Lenders and sellers are looking to stay competitive, especially in the Chicagoland market. Points and credits can help encourage otherwise skittish buyers to take the plunge.

Housing prices fluctuate, but we’re unlikely to see a decline anytime soon, so now is still a great time to get a piece of the dream, own your own home, and stop dealing with landlords and all the hassles of renting. 
The first step is reaching out to discuss your available options, the pros and cons of various loan products, and getting preapproved for a mortgage. Let’s continue the conversation — give me a call today!

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