Mortgage rates have more than doubled in a matter of months. This is making homes much less affordable for today’s buyers. It’s also softening the strong seller’s market we’ve experienced over the last few years. Because of this, it’s important for home sellers to use all of the tools at their disposal to make their homes as marketable as possible. It’s equally important for home buyers to make their home purchases as affordable as they can. One way you can do this is with an interest rate buydown. An interest rate buydown reduces the monthly mortgage payment for the home buying borrower.
A buydown can either lower the interest rate during the life of the loan or just during its initial years. We usually describe a permanent buydown as “discount points.” Discount points are prepaid interest. One discount point is equal to 1% of the loan amount. If you choose a temporary buydown, you reduce the interest rate of the loan during the first, second and/or third year only.
A fairly common temporary interest rate reduction is the 2-1 buydown. It lowers the initial interest rate of a 30-year, fixed rate loan by 2 percent for the first year of the loan and 1 percent during the loan’s second year. In years 3 through 30, you pay the loan at its full note rate. For example, if you were to purchase a home for $800,000 with 20% down and a 2-1 buydown on a fixed-rate loan at 6.7% interest, it would look like this:
2-1 Buydown
| 2-1 Buydown on $640,000 Loan | Interest Rate | Monthly Payment (principal and interest only) |
Monthly Savings | Annual Savings |
|---|---|---|---|---|
| Year 1 | 4.7% | $3,319.28 | $810.50 | $9,726.00 |
| Year 2 | 5.7% | $3,714.56 | $415.22 | $4,982.64 |
| Years 3-30 | 6.7% | $4,129.78 | 0 | 0 |
Permanent Verses Short-Term Buydown
The upfront cost of a short-term rate reduction equals the interest saved during the buydown period. So, in the example above, the 2-1 buydown would cost $14,708.56 which is the total interest saved in years one and two. There are options with short-term buydowns. In addition to the 2-1, there are also 1-0, 1-1 and 3-2-1 buydowns.
If you took the same $800,000 purchase price and $640,000 loan amount, you could also permanently buy down the interest rate by paying discount points. Right now, 2.25 discount points would permanently buy down the 6.7% interest rate on a 30-year fixed-rate loan to 5.875%¹. The upfront cost would be $14,400 because 2.25 discount points equal 2.25% of the $640,000 loan. That would save you almost $344 per month and $131,467 over the 30-year life of the loan.
Why Would a Home Seller Pay for a Buydown?
Why would a home seller fork out over $14,000 to pay for a loan buydown? Because the resulting, lower interest rate will have a much greater impact on their home’s affordability than a price reduction would. And home buyers often don’t have enough cash for their down payment, closing costs, and the cost of a buydown. Plus, federal guidelines limit how much borrowers can pay for loan fees and costs, and buydowns can push their fees beyond that limit.
To illustrate why a buydown would make a home much more affordable, let’s go back to the example we looked at earlier with an $800,000 home and $640,000 loan. The seller of that home would have to reduce their asking price by $68,000 to make their buyer’s mortgage payments the same as they would be if the seller paid the $14,400 for the 2.25 discount points. That makes the buydown a win-win for both the home seller and buyer!
Know Your Options
Today’s changing market is presenting challenges to home buyers and sellers. Interest rate buydowns are just one of many tools you can use to address and overcome those challenges. If you want to see if buydowns are a tool that makes sense for you, or talk about other options that can help you make the best choices when buying or selling a home, reach out to me today.
¹There’s no set amount for how much a discount point will reduce an interest rate. The reduction noted here was based on rates and costs when this was published, but mortgage rates, points and quotes fluctuate daily.