Did you know that mortgage interest rates reached historic lows during 2021 and 2022? That dip makes current interest rates all the more intimidating.
The good news? There are a few key tools homebuyers may be able to utilize to drive down their home interest rates, even today.
Enter: The mortgage rate buydown.
But what exactly is a buydown? Let’s dive into the definition, how buydowns work, and, most importantly, how you might benefit as a borrower.
Mortgage Loan Buydown: A financial arrangement where the borrower or a third party (think the home seller or builder) agrees to pay the lender additional cash at closing to “buy down” the interest rate. In exchange, the lender drops the borrower’s interest rate for a set period. Buydowns typically last only a few months or a few years but, in some cases, can be permanent.
The goal here is to make the mortgage loan payments more affordable for at least a set period of time by reducing the interest rate. The borrower might pay for the buydown to lock in lower monthly interest payments. The seller or builder might pay for the buydown to make the deal more enticing.
To really understand how a buydown works, we need to review the structure of a mortgage loan payment. That’s because a buydown could save you money by reducing your interest rate, one portion of your regular mortgage payment.
Here are the basics:
Principal: The original loan amount. Say you’re purchasing a $150,000 home with $50,000 down. You’ll borrow the other $100,000 from a mortgage lender, which becomes your principal</em>.
Interest: A fee you pay in exchange for the privilege of borrowing money. Basically, the lender charges you a percentage amount, say 8%, to use their money. So, you end up paying more than the principal amount over the life of the loan, and this is how your lender gets paid.
So, if you paid upfront to reduce your interest rate to, let’s say, 6%, your monthly payment would go down.
For example, you take out a mortgage for $150,000 at 8% interest. Your monthly principal and interest payment would be approximately $1,450 and some change.
Then, imagine the same loan amount at only 6% interest. That monthly principal and interest payment drops below $1,250.
You pay more up-front to pay less each month for however long the buydown lasts... with the goal that the lower interest rate would more than pay for the initial buydown investment. That’s right. Buydowns have the potential to save you thousands.
While you’re running numbers, keep in mind that while a buydown could save you some serious cash on a monthly basis and over the life of the loan, it will increase closing costs either for you or for a third party. You or a third party will need to pony up before signing on the dotted line. So, it’s always important to triple-check your math and confirm the situation with a mortgage professional.
There are three main types of buydowns you may want to be aware of: the 3-2-1 buydown, the 2-1 buydown, and the permanent buydown.
With a 3-2-1 buydown, you’ll see lower payments for the first three years of repayment. Each year, your interest rate will go up by one percentage point. So, you’ll see your full interest rate in the fourth year of the loan term.
It’s called a 3-2-1 buydown because you’ll receive a discount of three percentage points in the first year, two percentage points in the second year, and one percentage point in the third year.
If your initial interest rate was 8%, the 3-2-1 buydown could look a little something like this:
A 2-1 buydown is basically the same but, as the name implies, only lasts the first two years of repayment.
Again, each year, your interest rate will go up by one percentage point. In a 2-1 buydown, though, you’ll see your full interest rate in year [BOLD:] three of your mortgage loan repayment.
If your initial interest rate was 8% it could look a little something like this:
The third type is less common but potentially most powerful. A permanent buydown is just like it sounds: The borrower, or a third party on behalf of the borrower, pays the lender upfront at closing in exchange for a lower interest rate, for the life of the loan.
There are a few reasons permanent buydowns aren’t particularly common:
A mortgage loan buydown can be a powerful financial tool. By reducing interest rates, homeownership may become a lot more accessible.
If you’re interested, a mortgage professional can offer some personalized guidance. Whether you’re looking to drop your interest rate for a few years or the full loan term, be sure to speak with a seasoned pro before signing on the dotted line.