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The Science Of Incentive Buydowns To Reduce Your Mortgage Rate: How This Trend Is Supporting America’s Real Estate Industry

The Science Of Incentive Buydowns To Reduce Your Mortgage Rate: How This Trend Is Supporting America’s Real Estate Industry

mortgage buydowns

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Would-be home buyers who took a wait-and-see approach have watched in shock as mortgage interest rates almost doubled in the past year. An option to manage higher mortgage rates if you have some extra cash on hand is interest rate buydowns.

Borrowers entering the market are leaning heavily toward buying down their interest rates by paying points up front, according to Housing Wire

In the third week of January, nearly a quarter of all borrowers who locked in rates lowered their mortgage rates with buydowns of two points or more, 44 percent paid at least a full point and 57 percent paid at least a half point, according to Black Knight’s mortgage monitor report

The average rate for a 30-year fixed mortgage is 6.79 percent as of Feb. 17, up 18 basis points over the previous week. A month ago, the average rate on a 30-year fixed mortgage was 6.47 percent. At the current average rate, you’ll pay principal and interest of $651.26 for every $100,000 you borrow, according to data compiled by Bankrate.

Buydowns are all about paying more money upfront so you can save in the long run, so they only really make sense if the buyer plans to own the home for an extended period, according to Rocket Mortage.

Buydowns are an often-negotiated method for a borrower to get a lower interest rate by paying discount points at closing, also known as mortgage points or prepaid interest points. Paid-for upfront with a one-time fee, discount points can make the interest rate lower for the first few years of a mortgage or the full loan term, depending on the buydown structure.

A temporary form of buydown is available in which the points purchased reduce the interest rate for a given period at the beginning of the loan. This arrangement is typically paid for through funds escrowed by the seller. Since the interest rate is lower during this period, the borrower’s monthly mortgage payments are more affordable.

The cost for each discount point depends on how much the borrower takes out on the loan. Each point that a borrower pays is equivalent to 1 percent of the loan amount. For example, a mortgage lender may offer a borrower the ability to reduce their interest rate by 0.25 percent in exchange for a point. So, if the borrower is getting a $400,000 mortgage and is offered an interest rate of 4 percent, paying $4,000 would lower their interest rate to 3.75 percent.

Most buydowns are negotiated between buyers and lenders but buyers are not the only ones buying down mortgages. Sellers or builders in newer communities can also offer to a buyer a mortgage buydown as incentive to purchase their home. Once their communities are established, builders are usually less inclined to offer this kind of incentive, Rocket Mortgage reported.

“In my experience, buy-downs are most often used in new home construction and the builder typically pays for it,” said Karla Melgar, a senior loan officer with Embrace Home Loans in Rhode Island, in a Washington Post report.

There are some advantages to doing buydown rather than making a bigger down payment up front. Money is often tight in the first years of homeownership. A buydown that concentrates benefits in the first few years of the mortgage can be a savvy financial planning tool for borrowers who expect to have a higher income in the future, according to Peter Idziak, a Dallas attorney at residential mortgage law firm Polunsky Beitel Green.

1-1 Buydown

In a 1-1 buydown, your interest rate is 1 percent lower than your contract rate would for the first year. Here’s what that could look like for a 30-year fixed with a $400,000 loan amount at a contract rate of 7 percent interest.

YearInterest RateMonthly PaymentMonthly SavingsAnnual Savings
16%$2,398.21$263$3,156
2 – 307%$2,661.21$0$0
RocketMortgage

2-1 Buydown

A 2-1 buydown provides a discounted interest rate for the first 2 years of the loan’s term, making the interest rate 2 percent lower the first year and 1 percent lower the second. Based on a $400,000 30-year loan with a standard interest rate of 5 percent, the buyer would be expected to pay an interest rate of 3 percent the first year, 4 percent the second year and 5 percent from years 3 – 30.

YearInterest RateMonthly PaymentMonthly SavingsAnnual Savings
13%$1,686.42$460.87$5,530.44
24%$1,909.66$237.63$2,851.50
3 – 305%$2,147.29$0$0
RocketMortgage

The buyer would save about $8,380 in interest.

3-2-1 Buydown

A 3-2-1 buydown allows a buyer to pay less interest on a mortgage for the first 3 years with points paid upfront reducing the interest rate by 1 percent for each of those first 3 years.

YearInterest RateMonthly PaymentMonthly SavingsAnnual Savings
12%$1,478.48$668.81$8,025.70
23%$1,686.42$460.87$5,530.44
34%$1,909.66$237.63$2,851.50
4 – 305%$2,147.29$0$0
RocketMortgage

In this case, the total cost of the buydown would be around $16,400.

Even distribution over the life of the loan

To lower interest payments for the life of the loan, the total cost of the buydown would be higher. These buydowns usually cost $16,000 to $20,000 and save buyers around $85,550, but they only make sense for buyers who plan to stay in the home for more than five years, according to Rocket Mortgage. An evenly distibuted rate reduction prevents the interest rate and thus their monthly mortgage payments from ever increasing.

Using the same $400,000 mortgage example, the buyer would pay a monthly mortgage payment of $2,147.29 for a loan without any discount points applied. If the buyer buys down the mortgage and pays 4 percent interest throughout the loan term, their payments would look like this:

YearInterest RateMonthly PaymentMonthly SavingsAnnual Savings
1-304%$1,909.66$237.63$2,851.50
RocketMortgage

There are disadvantages to doing a buydown rather than making a bigger downpayment. For example, borrowers who put less than 20 percent down on a conventional loan must usually buy mortgage insurance. The cost of mortgage insurance over the life of the loan could outweigh any benefit a borrower would get from using their money on a temporary buydown, Idziak told the Washington Post.

“The 2-1 buy-down program is a phenomenal way for buyers to ease into their new mortgage payment,” Cox said.