The low mortgage interest rates experienced over the last five years have helped many consumers purchase homes due to lower, more affordable, monthly payments. Now that rates have started to climb, consumers may be concerned about affording their dream home. One common question people have is about a mortgage “buydown” on a home mortgage interest rate. What does that mean exactly and how can the consumer know for sure there is a benefit to them? A mortgage buydown involves paying a fee up front in order to decrease the interest rate, and thereby the monthly mortgage payment, either temporarily or permanently. Each individual then must calculate whether the reduction in interest cost outweighs the cost of the upfront fee paid. A buydown can be an attractive alternative for those that want a lower payment in the short term, but don’t want to take the risk of an adjustable rate mortgage.
The temporary buydown only reduces the interest rate and mortgage payment in the early years of the loan. This type of buydown is meant for those borrowers that foresee their income rising over the period of the interest rate reduction. The lower initial payment is used to qualify the borrower giving them greater purchasing power. The fee paid for the buydown is deposited into an escrow account for the borrower, and as the borrower makes the reduced monthly mortgage payment, the escrow account funds the interest shortfall. The table below illustrates three examples of the temporary buydown and overall cost.
On a 3-2-1 buydown, the mortgage payment is calculated with a rate that is 3 percent, 2 percent and 1 percent respectively, below the rate on the loan during the first three years. On a 2-1 buydown, the mortgage payment in years one and two is calculated at rates 2 percent and 1 percent below the loan rate. On a 1-1 buydown, the mortgage payment in years one and two is calculated at a rate 1 percent below the loan rate.
The 3-2-1 buydown provides for the largest payment reduction, but also requires the largest amount to be placed into the escrow account. In general, it’s best to obtain the smallest buydown necessary to qualify for the loan if the amount put into escrow is paid for by the borrower. The temporary buydown can be an attractive alternative for those consumers that want a lower payment in the short term, but don’t want to take the risk involved with an adjustable rate mortgage. In some instances, the builder or seller may be willing to pay the amount needed for the escrow account to sell the home and make it more attractive to potential buyers.
The permanent buydown, sometimes referred to as a loan discount, will provide for a reduced interest rate and payment for the term of the loan. The cost to buy down the rate for the term of the loan is much higher than the temporary buydown due to the potential interest saved over the entire life of the loan. The cost of the permanent buydown is calculated based on a percentage of the loan amount. For example, in order to buydown the rate one quarter of 1 percent from 5 percent to 4.75 percent, the cost may be 1 percent of the loan amount. Using the example of $150,000 as our loan amount, the cost to buydown one quarter of 1 percent is $1,500. If the borrower were to buy down the loan rate from 5 percent to 4 percent, the cost could then be $8,438. Determining whether it would make sense for the borrower to buydown the rate permanently will depend on how long the borrower intends to have the mortgage and/or stay in the home as illustrated in the table below.
You can see that the lowest rate provides for the greatest payment reduction, but at the largest cost. The breakeven point, due to the lower payment relative to the cost, occurs between month 94 and 95 – roughly in eight years. The borrower may decide whether a permanent buydown makes sense by predicting how long they will have the mortgage and/or home and whether the breakeven point in months will be attained.
Low rates are still possible even when market rates are on the rise, which can allow borrowers to afford the home of their choice. The determination of temporary or permanent rate buydown can only be determined based scenario variables, as every situation may be different. The temporary rate buydown is a great solution for those that can foresee their earnings rising in the near future. The permanent buydown is a great solution long term to retain the lowest rate now and have it throughout the mortgage term. There are many ways to take advantage of lending practices to assure an affordable monthly payment. Homeownership, the American dream, is within reach.
Keith Valentine and Jeff Carlson are with Mission Hills Mortgage.