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Mortgage Buydowns - How to Buy Down a Mortgage

Figuring Out Mortgage Buydowns

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Mortgage Buydowns Reduce the Interest Rate and Payments

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Mortgage buydowns -- what is that? You've probably heard the term before, but if you're like most people, it might not make a lot of sense to you. In part, the reason it may sound confusing is because a mortgage buydown rarely results in a permanent lower monthly payment nowadays; it's only temporary.

Mortgage Buydowns Do Not Involve Negative Amortization

For many borrowers, a mortgage buydown is more advantageous than choosing, say, an adjustable loan with a payment option that allows for negative amortization like an Option ARM. That's because with mortgage buydown programs, your mortgage payment always includes principal and interest. This means every time you make a payment, your mortgage balance grows smaller instead of bigger.

Basics of Today's Popular Mortgage Buydowns

Popular mortgage buydowns work like this.

  • Payments are reduced and figured on a lower interest rate over a specific term.
  • The difference between the "real" note rate and the lowered interest rate is paid in cash by the seller or the buyer.
  • Think of it like a subsidy. It's like socking away $1200 in the bank and withdrawing $100 every month for 12 months to help make your mortgage payment.

The 3-2-1 Mortgage Buydown

  • This is a 30-year fully amortized mortgage.
  • The interest rate increases 1% every year for the first three years.
  • Then the interest rate is fixed for the remaining term.

Here is an example. Say your loan balance is $350,000 and the interest rate is fixed at 6.75% for 30 years. The seller (or you) could "buy down" the interest rate by paying a lump sum of $15,853. This is how it works:

  1. First-year interest rate is 3.75%, payable $1,621 per month.
  2. Second-year interest rate is 4.75%, payable $1,826 per month.
  3. Third-year interest rate is 5.75%, payable $2,043 per month.
  4. Years four through 30, interest rate is 6.75%, payable $2,270 per month.

  • First-year savings (as compared to $2,270 per month) is $649 per month or $7,790.
  • Second-year savings (as compared to $2,270 per month) is $444 per month or $6,332.
  • Third-year savings (as compared to $2,270 per month) is $228 per month or $2,731.

Add up the annual savings: $7,790 + $6,332 + $2,731 = $15,853. Therefore, it costs $15,853 to buy down the interest rate and payments for three full years.

Benefits of 3-2-1 Mortgage Buydown

  • The borrower qualifies for this loan at the 3.75% interest rate and payment amount of $1,670 versus the real rate of 6.75% and the payment of $2,270.
  • Instead of the payment jumping all at once, it goes up in smaller increments, about $200 each year, for the first three years.
  • It keeps payments low for 36 months for borrowers whose income is expected to later increase. Perhaps a spouse is returning to work after a hiatus or a person expects to graduate and land a higher paying job with that newly earned degree.

The 2-1 Buydown Mortgage

  • This is a 30-year fully amortized mortgage.
  • The interest rate increases 1% every year for the first two years.
  • Then the interest rate is fixed for the remaining term.

Here is an example. Say your loan balance is $350,000 and the interest rate is fixed at 6.75% for 30 years. The seller (or you) could "buy down" the interest rate by paying a lump sum of $8,063. This is how it works:

  1. First-year interest rate is 4.75%, payable $1,826 per month.
  2. Second-year interest rate is 5.75%, payable $2,043 per month.
  3. Years three through 30, interest rate is 6.75%, payable $2,270 per month.

  • First-year savings (as compared to $2,270 per month) is $444 per month or $6,332.
  • Second-year savings (as compared to $2,270 per month) is $228 per month or $2,731.

Add up the annual savings: $6,332 + $2,731 = $8,063. Therefore, it costs $8,063 to buy down the interest rate and payments for two full years.

Note: Lenders typically require a 10% down payment for a 3-2-1 Buydown and a 5% down payment for a 2-1 Buydown. There are other types of mortgage of mortgage buydowns, but these two are the most popular. In parts of the country where sales prices are very low, it's not cost prohibitive to do a permanent 1% interest buydown.

At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.

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