What Is A Rate Buydown?

Rates are up, and understandably, people are searching for ways to obtain a lower interest rate, and that has led to a lot of conversation right now about rate buydowns.  The most common of these are temporary 2-1 buydowns and 3-2-1 buydowns.

A temporary buy-down lowers the borrower’s effective interest rate for a limited period, allowing borrowers to enjoy reduced monthly payments during the early years of the mortgage.  There is a fee for the buydown that is roughly equal to the amount of interest saved by the buydown, so buydown’s aren’t cheap.   These buydowns are most commonly paid by builders as an incentive.  The fee for the buy-down is generally put into an escrow account at closing. The borrower then pays a monthly payment based on the reduced or “bought down” rate and the funds from the escrow account are used to make up the difference or “subsidize” the payment during the early years of the mortgage.

For conventional mortgages, the general rule is that the rate can be reduced for a maximum of 3% and over a maximum of 3 years, and the rate can increase by no more than 1% per year.  Not all lenders allow for all types of buydowns – many are limited to either the 3-2-1 or 2-1 buydowns or possibly both.  These are the various possibilities, which are not offered by all lenders:

• 1-0 Buydown: The payment rate is 1% lower than the note rate for the first year on a new loan and then returns to the note rate
• 1-1 Buydown: The payment rate is 1% lower than the note rate for the first year on a new loan and then returns to the note rate
• 2-1 Buydown: The payment rate 2% lower than the note rate for the first year, a payment rate that is 1% lower than the note rate in the second year on a new loan, and then returns to the note rate
• 1-1-1 Buydown: A payment rate 1% lower than the note rate for the first three years on a new loan, and then returns to the note rate
• 3-2-1 Buydown: A payment rate 3% lower than the note rate for the first year on a new loan, then 2% lower than the note rate in the second year, 1% lower than the note rate in the third year, and then returns to the note rate

The “note rate” is the locked rate.  So, if your locked note rate is 7%, here is what each of these options looks like:

• 1-0 Buydown: Your payment rate is 6% for the 1st year and then 7% for all of the years after
• 1-1 Buydown: Your payment rate is 6% for the 1st and 2nd year and then 7% for all of the years after
• 2-1 Buydown: Your payment rate is 5% for the 1st year, 6% for the 2nd year, and then 7% for all of the years after
• 1-1-1 Buydown: Your payment rate is 6% for the 1st, 2nd and 3rd years, and then 7% for all years after
• 3-2-1 Buydown: Your payment rate is 4% for the 1st year, 5% for the 2nd year, 6% for the 3rd year, and then 7% for all of the years after

To determine the buydown fee, it is necessary to determine the interest savings as a result of the buydown.  Let’s look at the cost for 3-2-1 and 2-1 buydowns, the most common.

If a buyer is qualified for a 30 year fixed rate mortgage at an Note rate of 7.00%, with a 3-2-1 buydown, their interest rate is reduced by 3% for the 1st year, 2% for the 2nd year, 1% for the 3rd year, and then goes back up to the full rate for the 4th year and beyond.  Here is what that looks like:

And here is what the 2-1 buydown looks like with the same 7% Note Rate:

Another less expensive option is a 1-1 Buydown:

Frequently Asked Questions

Who usually pays for a buydown?
Buydowns are most frequently paid by builders as an incentive in new construction, but in some cases can be paid by the lender, or even a 3rd party such as a realtor.  In many cases buyers are not allowed to pay for these.   Ideally, the seller or builder would accept a concession to pay this fee, and that is what we have traditionally most often seen.

How does the buydown impact qualification?
The buyer needs to qualify based on the highest rate, the full unsubsidized rate and payment.

What are the advantages of a buydown?
A buydown can be helpful for first time home buyers in the early years of the mortgage and their career when funds are tight and they have lots of new expenses for furniture, home improvements, etc.

What are the disadvantages of a buydown?
First off, there is pending payment shock as the monthly payment goes up in the future.  Additionally, there may be more beneficial ways to spend the fee that would fund the buy down.  Such as repair concessions to replace a roof, update a kitchen, etc. which could possibly be negotiated for the sellers to complete before closing, and then saving the buyer’s that expense.

What happens to the remainder of funds in the buydown account if the home is sold or refinanced before the end of the buydown period?
This will depend on the buydown agreement – and ideally, the buydown agreement will specify that the unused funds in the account be used to reduce the loan balance.

Is there any such thing as a permanent rate buydown?
Yes, you can obtain a permanent reduction in your interest rate simply by paying discount points to buy the rate down.  Discount points are also known as prepaid interest points or mortgage discount points.  You can generally reduce your rate by about .75% by paying about 2.5 points.  On today’s ratesheet, if your loan amount is $400,000, then the cost to permanently buy the rate down by about .75% would be about $10,000.  This one-time fee is paid at closing, paid buy the borrower unless the sellers have agreed to pay some closing costs.