When interest rates are higher, you will hear a lot about "buydowns." A buydown is a way to pay money up front to get a lower interest rate, either for the first few years of a loan or for its whole life. Here is how it works, in plain English.
Two kinds of buydowns
• Temporary buydown: Cash is set aside at closing to lower your payment for the first one to three years. Your payment then rises to the full amount. A common example is a 2-1 buydown: your rate is 2 percentage points lower in year one and 1 point lower in year two, then it returns to the note rate in year three.
• Permanent buydown (discount points): You pay a fee, called points, at closing to get a lower rate for the full term of the loan. One point equals 1 percent of the loan amount.
An example of a 2-1 buydown
These numbers are for illustration only and are not today's rates. They assume a $400,000 loan on a 30-year fixed mortgage with a note rate of 6.5 percent. They show principal and interest only, not taxes or insurance.
|
Year |
Rate |
Monthly payment |
Savings per month |
Savings for the year |
|
1 |
4.5% |
$2,027 |
$502 |
$6,018 |
|
2 |
5.5% |
$2,271 |
$257 |
$3,085 |
|
3 and after |
6.5% |
$2,528 |
$0 |
$0 |
The total subsidy over the first two years is about $9,100. That is the amount that has to be funded at closing, usually by the seller or builder, though a buyer can pay for it too.
An example of a permanent buydown
Using the same $400,000 loan, suppose one point ($4,000) lowers the rate from 6.5 to 6.25 percent. The payment drops from about $2,528 to about $2,463, a savings of roughly $65 a month. It would take around five years of those savings to earn back the $4,000, so a permanent buydown makes the most sense if you expect to keep the loan and the home for a long time. How much a point lowers the rate varies by lender and loan, so ask for exact quotes.
What buyers should know
• A buydown lowers your payment, but it does not lower the price of the home or the rate on your note. Plan to be able to afford the full payment in year three.
• Lenders generally approve you based on the full note rate, not the lower temporary rate. Ask your lender how your loan will be qualified.
• Ask which loan programs allow buydowns, and how much a seller can contribute under your loan type.
• Compare a buydown with other uses of the same money, such as a price reduction or help with closing costs. The best choice depends on your plans.
• If rates fall, you may be able to refinance, but nobody can promise that they will.
What sellers should know
A buydown can be a way to attract buyers without cutting your list price. It costs you money, though, so ask for a net sheet that shows what you will walk away with under each option. Minnesota's purchase agreement has a line for the seller's contribution toward the buyer's costs, which can include prepaid items and mortgage discount points. Any contribution has to fit within your buyer's loan program limits.
Is a buydown right for you?
It depends on your budget, how long you plan to stay, and what the seller is willing to do. I'm happy to sit down with you and a trusted lender and run the numbers side by side. Call me at 651-248-4855 or email shannon@freshstartrealtymn.com.
This post is general information, not financial or lending advice. The examples are illustrations, not quotes, and actual terms depend on the lender, the loan program and your credit. Talk with a licensed mortgage professional about your situation. We can send you a referral to apreffered partner.