When you decide to buy a home, you commit to paying not just the home's purchase price but also the interest rate on your mortgage loan, which represents the cost of borrowing money from your mortgage lender. Many buyers are seeing a decline in their purchasing power and an increase in their future monthly payments as a result of the current high mortgage rates. While delaying a purchase until mortgage rates are low once more may seem enticing, it isn't always possible. Fortunately, you can consider buying down your mortgage as one option. In other words, you can lock in a lower mortgage rate and keep more of your monthly income by paying a little bit more money upfront.
What is a buydown on a mortgage?
In a financial arrangement referred to as a "mortgage buydown," the buyer, seller, or builder agrees to pay mortgage points (also called discount points) at closing in exchange for a lower interest rate. The difference between the standard rate and the new rate will be covered by this one-time fee. Depending on your lender and whether you want a permanent or temporary mortgage buydown rate, there are various ways to buy down a mortgage.
What does a buydown on a permanent mortgage look like?
With this choice, you'll pay your lender discount points at closing to purchase a cheaper rate that will apply to the whole loan term. The rate will never go up, unlike a temporary mortgage buydown.
What does a temporary buydown of a mortgage look like?
Your mortgage interest rates will initially remain low under this arrangement before rising over time. You may hear phrases like "3-2-1 buydown" or "2-1 buydown" used to describe temporary mortgage buydown structures. Later, we'll discuss how each arrangement appears.
How much does buying down a mortgage rate cost?
Each mortgage point that is paid by the borrower normally equals 1% of the loan balance and lowers your interest rate by 0.25%. For instance, one point would reduce the interest rate on a mortgage from 6% to 5.75%. However, lenders may differ in how much each discount point reduces the rate.
Consider a scenario in which a mortgage lender grants you, the borrower, the chance to lower your interest rate by 0.25% in exchange for purchasing one point. In other words, if your loan is for $500,000 and the interest rate is 6%, you can pay $5,000 (1% of $500,000) to reduce your interest rate to 5.75% with one discount point.
Different ways to buy down a mortgage
Below is a summary of the three popular temporary mortgage buydown arrangements: a "3-2-1 buydown", a "2-1 buydown", and a "1-0 buydown".
A 3-2-1 buydown
The borrower can benefit from lower interest rates for the first three years of the loan thanks to a 3-2-1 buydown. The interest rate is 3% lower than the going rate in the first year and rises by 1% annually for the following two years. The rate will be the same for the fourth year as it was when you locked up your mortgage.
Let's assume that a buyer is approved for a 6% interest rate, 30-year mortgage loan. The timetable will be as follows if the buyer chooses they want to reduce the interest rate for three years using a 3-2-1 buydown:
- In the first year, the buyer will pay a 3% interest rate.
- In the second year, the buyer will pay 4% in interest.
- In the third year, the buyer will pay a 5% interest rate.
- From years 4 through 30, unless they choose to sell or refinance, the buyer will pay the full 6%.
A 2-1 buydown
Similar to the 3-2-1 arrangement, a 2-1 mortgage buydown only offers the lower rate for the first two years of the loan's life. This would result in a first-year interest rate for the buyer that is 2% lower than the usual rate and a second-year interest rate that is 1% lower.
A 1-0 buydown
A 1-0 buydown is a 1% reduction in interest rates in just the first year.
Reduced Interest Rates That Are Distributed Equally
A buyer might choose to buy more points by forking over a higher upfront fee if they would like to lower their interest rate over the course of the loan. The interest rate and mortgage payments for the buyer won't rise by doing this. For an anticipated monthly payment at various interest rates, use a mortgage calculator.
Who is eligible to acquire a mortgage buydown?
Although a mortgage buydown will ultimately benefit the buyer, builders and sellers can also decide to buy discount points to reduce the buyer's interest rate.
Pay for it yourself.
A buyer and their lender generally bargain over a mortgage buydown. After planning for your down payment, if you still have money left over, you can use it to purchase mortgage points up front in exchange for a lower interest rate.
Ask the seller to pay for it
A seller may offer to pay for a mortgage rate buydown as an enticement for potential purchasers to buy their house if they need to sell it soon. If so, as part of the seller's concessions, or the closing costs the seller has agreed to pay, the seller will make a one-time deposit into escrow or pay points over the whole loan. The mortgage lender will use this money to pay the buyer's interest rate reduction so they may afford the house.
Use a builder's incentive for closing costs.
Builders of new homes may provide financial incentives to customers who purchase them. The money can be used to pay for closing expenses, such as lowering your interest rate.
Make use of gifts
You can use money given to you as a present from family or close friends to pay for a mortgage rate buydown. However, there are limitations on how much you can receive as a gift before being subject to the gift tax.
Will refinancing your mortgage be profitable?
When a seller or builder offers to cover the cost of buying down your mortgage, a mortgage buydown is most advantageous. Mortgage buydowns are still appropriate in some situations, though, if a buyer decides to cover the points out of pocket. If you want to buy down your mortgage, you'll need to have enough resources to pay for the down payment, closing charges, and buydown costs all at once. Lowering the interest rate for the first few years or the duration of the loan may be advantageous if this sounds like a good option for you.
A mortgage buydown typically only makes sense if the buyer plans to keep the house for a long time and will eventually reach the breakeven point, or the period of time it will take to recoup the cost of the discount points. Your term, interest rate, and loan amount all affect when you break even. How to determine the breakeven point is as follows:
Breakeven point = (cost of the mortgage buydown) / (monthly savings)
Consult your mortgage lender
Be sure to work with a local and experienced mortgage lender to find the best mortgage buydown arrangement for you, or whether a mortgage buydown makes sense at all for your situation. Laura Larson works with great lenders and will be happy to recommend someone who can best assist you.