When mortgage rates go up, lenders might offer a way to lower your interest rate by paying extra, called a mortgage rate buydown. This can be either permanent or temporary, and knowing the difference can help you decide if the cost is worth it.
What is a mortgage rate buydown?
A mortgage rate buydown, often called a “buydown mortgage,” is a financing option that allows a borrower to secure a lower interest rate on their mortgage for a set number of years or the entire loan term. To achieve this, the borrower pays mortgage points at closing, which covers the difference between the regular rate and the reduced rate.
How Does a Buydown Mortgage Work?
A mortgage rate buydown can be arranged in various ways, with terms that can differ from lender to lender. The setup depends on whether you choose a permanent or temporary buydown rate.
How a Temporary Mortgage Rate Buydown Works
Lower Initial Rate: With a temporary buydown, your interest rate starts lower but increases over time. The initial rate is reduced for a set period, and borrowers can choose plans with rates up to 3% lower than current mortgage rates. For instance, if the market rate is 5%, a 2-1 buydown would let you pay an initial rate of 3% for the first year.
Gradual Rate Increase: The rate rises each year according to the plan. Typically, rates go up by 1% per year for the rest of the buydown period. In the 2-1 example, the rate would increase to 4% in the second year.
Fixed Final Rate: After the buydown period, the rate returns to the original market rate, such as 5% in this example, and stays fixed for the rest of the loan term.
Cost at Closing: The cost of the buydown is paid upfront at closing. You’ll find the charge listed on Page 2 of your loan estimate under the “loan costs” section.
How a Permanent Mortgage Rate Buydown Works
- Rate Reduction for the Entire Loan Term: A permanent buydown lowers your interest rate for the entire duration of the loan. The lender offers a reduced rate by charging mortgage points, where more points mean a greater reduction in the rate.
- Fixed Rate: As long as you maintain the loan, the rate remains unchanged. Unless you have an adjustable-rate mortgage (ARM), the reduced rate stays the same throughout the loan term.
- Buydown Cost at Closing: The cost of the buydown is added to your closing costs, and you pay this upfront.
Types of Mortgage Buydowns
There are two common types of temporary mortgage buydown options, though lenders may offer variations. Here’s a brief overview:
- 3-2-1 Buydown: This buydown starts with a rate 3% below the current market rate, and each number in “3-2-1” represents how much lower the rate is compared to the prevailing rate. For example, if you’re offered a 3-2-1 buydown at a cost of $12,750, and you’re borrowing $425,000 in a market where the rate is typically 6% for a 30-year fixed-rate loan.
To decide if the buydown is worthwhile, calculate your break-even point by dividing the $18,503.28 in total savings from the first three years by the $12,750 in loan costs. This gives you a result of 1.45, meaning it will take almost one-and-a-half years to break even. If you plan to stay in the home for at least that long, the buydown could be a smart choice.
2-1 Buydown Mortgage: This option works similarly to the 3-2-1 buydown but only provides savings for the first two years. Be sure to check the total costs to ensure you’ll recover your investment, especially if you plan to live in the home for only a short period.
How to pay for a mortgage buydown
There are four ways to pay for a mortgage rate buydown. Here’s how each option works:
- Gift Funds: If you receive a gift from family or friends, you may be able to use those funds to pay for a mortgage rate buydown.
- Pay Cash: If you have extra cash on hand, you can use it to buy down your mortgage rate. However, make sure to calculate the break-even point to ensure it’s worth the investment.
- Ask the Seller to Pay: Some sellers may offer to cover the cost of a rate buydown to make their home more attractive. If they suggest a “preferred lender,” be sure to shop around to find the best rate.
- Use a Builder’s Closing Cost Incentive: Homebuilders might offer incentives if you use their in-house mortgage company. These funds can often be used to cover closing costs, including buying down your rate.