How an Interest Rate Buy Down Works

It’s no secret that buying a house is an expensive undertaking. When you get a mortgage, you’re not only committing to paying the purchase price of the home, you’re also agreeing to pay for the privilege of borrowing money.  While it might seem like you can only hope that interest rates are low, despite predicted trends and rate hikes, when you’re ready to obtain a loan, there’s actually something you can do to ensure your mortgage payments are more manageable in the future. By paying more money upfront, you can score a lower interest rate on your mortgage.  This financing technique is called a mortgage buydown. Read on to learn what a buydown is, how it works and whether it’s right for you.

What Is A Buydown On A Mortgage?

A buydown is a way for a borrower to obtain a lower interest rate by paying discount points at closing. Discount points, also referred to as mortgage points or prepaid interest points, are a one-time fee paid upfront. In the case of discount points, the interest rate is lower for the loan term.  In an alternate form of buydown, the points purchased reduce the interest rate for a given amount of time 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 time, the borrower’s monthly mortgage payments are more affordable.

How Much Does It Cost To Buy Down An Interest Rate?

The cost for each discount point depends entirely on the amount you, as the borrower, take out on the loan. Each point that a borrower pays is equivalent to 1% of the loan amount. For example, a mortgage lender may offer a borrower the ability to reduce their interest rate by .25% in exchange for a point. So, if the borrower is obtaining a mortgage for $400,000 and is offered an interest rate of 7.5%, paying $4,000 would lower their interest rate to 7.25%.  In short, for every 10% of your loan amount, you can buy down your rate .25%.

Who Can Buy Down A Mortgage?

Although it’s the buyer (or borrower) who benefits from a buydown, the buyer isn’t always the one who buys down a mortgage. Sellers and builders can also be responsible for purchasing points to lower the buyer’s interest rate.

Buyers

The majority of buydowns are negotiated between buyers, sellers and lenders. Home buyers offer to pay a specific number of points upfront, and in return, they receive a lower interest rate, making their mortgage more affordable for a certain number of years or over the loan term, depending on the buydown structure.

Sellers

Sellers may also offer to buy down a buyer’s mortgage to incentivize the buyer to purchase their home. In these circumstances, the seller will make the one-time payment and deposit it into an escrow account or pay for points over the entire loan term as part of seller concessions. This payment, or subsidy, provides the lender with the funds necessary to lower the buyer’s interest rate so that the buyer can more easily afford their home loan. However, to make up for this expense, especially in a seller’s market, the seller often will add the cost of the subsidy to the purchase price of their home.

Builders

Like sellers, builders may also offer to pay points to buy down buyers’ mortgages. Typically, a builder will make these upfront payments to entice early buyers to purchase properties in their newly built communities. Once their communities are established, builders are usually less inclined to offer this kind of incentive.

How Buydowns Are Structured

Since buydowns are negotiated, they can be arranged in a variety of ways. In addition to buydowns over the life of the loan, common structures that lenders use are the 1-0 buydown and the 2-1 buydown. A 3-2-1 buydown is less common. However, regardless of the structure, the principles are the same.  The buyer, seller or builder will pay the lender the difference between the standard interest rate and the lowered rate through points at closing. The buyer will benefit from the reduced interest rate until the buydown expires, usually after a few years. Not all buydowns expire. If one does, the buyer will have to pay the standard interest rate for the remainder of the term, which will cause their monthly mortgage payments to increase.

1-0 Buydown

With a temporary 1-0 buydown, your interest rate is 1% lower than what your contract rate would be for the rest of the loan for the first year.

2-1 Buydowns

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

3-2-1 Buydowns

A 3-2-1 buydown enables a buyer to pay less interest on their mortgage for 3 years after obtaining the loan. The points paid upfront reduce the interest rate by 1% for each of those first 3 years.  Let’s say a buyer wants to borrow $400,000 and qualifies for a 30-year fully amortized mortgage at an interest rate of 5%. The buyer decides they want to lower their interest rate for the first 3 years with a 3-2-1 buydown. In this scenario, the buyer would pay an interest rate of 2% the first year, 3% the second year and 4% the third year but would have to pay the full 5% from years 4 – 30.

Evenly Distributed Interest Rate Reductions

In some circumstances, a buyer may choose to purchase enough discount points to reduce their interest rate evenly over the life of the loan. By obtaining a buydown loan, the buyer pays an even larger sum upfront that prevents their interest rate and thus their monthly mortgage payments from ever increasing.

Should I Buy Down My Mortgage Rate?

Buydowns are most beneficial when a seller or builder offers to pay the discount points on behalf of the buyer without significantly increasing the purchase price of the home. However, if the buyer intends to pay the points themselves, there are certain circumstances in which mortgage buydowns are more suitable.  To begin, you must have enough savings that you can affors to pay for a down payment and closing costs and still have a significant amount of cash left over. If that’s the case, having lower payments in the first few years may be beneficial if you expect your income to be considerably higher in the future.  For example, a buydown may make sense for a graduate student who believes their income will double after receiving their degree. Buying down a mortgage would also make sense if a stay-at-home parent were planning to return to work a couple of years after obtaining their loan. But keep in mind that buydowns are all about paying more money upfront so you can save money in the long run. Therefore, buydowns only really make sense if the buyer in question intends to own the home for an extended period of time.

The Breakeven Point

To determine if a buydown is worthwhile, you must calculate the breakeven point. The breakeven point is the amount of time it’ll take to recoup the cost of the discount points required to lower your interest rate. To do the calculation, you divide the cost of the discount points by the monthly savings.  Breakeven Point = (The Cost Of Points)  ∕  (Monthly Savings)  Let’s take a look at a simplified example of how this would work. If you’re looking to obtain a 30-year, $400,000 mortgage with an interest rate of 5%, and your lender charges you four points to reduce your interest rate by 1%, you would first calculate the cost of the points.  Since each point costs 1% of the purchase price, the total cost would be $16,000. By paying 4% in interest instead of the standard 5%, your mortgage payments would drop from $2,147.29 to $1,909.66. Therefore, your monthly savings would be $237.63.  $16,000 divided by $237.63 comes to 67.33, so 67 months is the breakeven point. That means it would take you about 5 years, 7 months to recoup the money you’d have to spend on discount points.  If you, as the buyer, think there’s a chance you’ll sell the home or refinance before the 67-month mark, a buydown wouldn’t make sense for you. Instead, you’d want to think about making extra payments, as you can also save money on interest by paying off your mortgage early.

The Bottom Line: Buydowns Can Save Buyers Cash

Generally speaking, mortgage buydowns enable buyers to lower their monthly mortgage payments either permanently or in the first few years of their loan. By paying discount points at closing, buyers can reduce their interest rates slightly, which can lead to long-term savings.  However, buydowns are not appropriate for all buyers. If you’re interested in buying down your mortgage, you should calculate your breakeven point to ensure the amount of time it takes to recover the money spent on points is worth the upfront investment. 

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