Today’s homebuyers are suffering from insomnia because of sharply rising interest rates, which have more than doubled in the last year and are already at their highest point in twenty years. These higher rates, which are currently averaging around 6%, are increasing the monthly housing prices for new purchasers by hundreds or even thousands.
However, purchasers who feel forced to pay excessive interest rates should be aware that a mortgage rate buy-down offers a chance to reduce those rates.
In keeping with its name, a mortgage rate buy-down entails paying money up in advance to temporarily lower the loan’s interest rate. This will allow the buyer to ease into the property market by temporarily lowering their monthly mortgage payments. Best of all? Buyers don’t pay for buy-downs. Builders, and sometimes even lenders front the costs to entice cash-strapped buyers to the closing table.
Homebuyers might be relieved to learn that there is a no-cost alternative to high rates, but they might also question if there is a catch. Here is a guide on mortgage rate buy-downs, their benefits, and drawbacks, and how to determine whether obtaining one is best for you.
Why the mortgage rate buy-down is popular today
The rate buy-down has gained appeal once again since the high-interest rate era of the 1970s. While it’s evident that purchasers stand to gain from this, builders and sellers who are unable to locate a buyer can also gain since agreeing to pay for a buy-down can aid in closing the sale.
“With increasing interest rates, sellers will likely be looking for great ways to incentivize buyers, and this product would be a great way to do that,” says Adam Fuller, a senior loan officer at Mortgage 1 in Grand Rapids, MI.
To win a borrower’s business, even lenders, many of whom are competing for business these days, may offer to reduce their interest rate, as is the case with Rocket’s Inflation Buster buy-down.
Homebuyers who aren’t given the option of a buy-down can always inquire about this with their seller, builder, or lender. It never hurts to inquire even if not everyone will be.
How a mortgage rate buy-down works
Simply put, a buy-down offers a property buyer lower monthly mortgage payments for a predetermined period, usually one to three years. The interest rate then goes back to the earlier, higher rate.
The type of a buy-down might vary depending on the borrower’s needs. Here are a few of the most popular ones now in use.
Types of buy-down loans
2-1 Buy-Down
With a 2-1 buy-down, your interest rate will be 2% below market for the first year of your mortgage. It will be 1% less in the next year.
Here’s how that works out with a $300,000 house and a 30-year fixed mortgage with a 5% down payment and a 7% interest rate.
The interest rate is 5% in Year 1 and the mortgage payment is $1529.94 per month. The annual savings amount to $4,394.05
The interest rate is 6% in Year 2, with a $1,708.72 monthly mortgage payment. The annual savings amount to $2,248.72.
Year 3’s interest rate is 6%, with a $1,708.72 monthly mortgage payment. The annual savings amount to $2,248.72.
The interest rate is 7% in Years 4 through 30 and the mortgage payment is $1,896.11 per month.
Over the course of the loan, savings total $13,068.51.
3-2-1 Buy-Down
This buy-down results in a temporary reduction in the interest rate payable by the Borrower for the first three years. As the name implies, the interest rate is reduced by 3% in the first year, 2% in the second year, and 1% in the third year. The money will be returned to the original note after the final 27 years (or as seen below, Years 4–30).
What occurs when you obtain a $300,000 30-year fixed-rate mortgage with a 5% down payment is as follows.
In Year 1, the interest rate is 4%, and the monthly mortgage payment is $1,360.63. Savings total $6,425.74 per year.
In Year 2, the interest rate is 5%, and the monthly mortgage payment is $1,529.94. The amount saved is $4,394,05.
How much does a mortgage rate buy-down cost?
The charge for the buy-down (paid for by the seller, builder, or lender) will be equal to the amount saved in interest because a mortgage rate buy-down is effectively pre-paid interest.
This is the amount the seller (or builder or lender) would have to pay upfront in the situation mentioned earlier for a 3-2-1 buy-down, which would save the buyer $13,068.51 in interest. This money is then put into an escrow account which serves as a monthly supplement to the buyer’s mortgage payments for the duration of the buy-down.
Buy-downs may seem like a bad bargain for builders or sellers, but they are frequently preferable to not being able to sell a home at all. (A lender winning the loan is also preferable to losing that client.) Even if a builder or seller might also lower the property’s price, some people could want to maintain their sales price high and pay for the buy-down instead. A buy-down can thereby help the buyer, seller, and lender by bringing about arrangements they might not otherwise be able to.
Pros and cons of a mortgage rate buy-down for buyers
The mortgage rate buy-down helps buyers today since it allows them to gradually increase their monthly payments while still saving money during the lower interest period.
The major danger of a buy-down, according to Holden Lewis, a home and mortgage expert at NerdWallet, is that you’ll become used to spending the money you’re saving and struggle to make your monthly payments when you eventually have to pay the full interest rate.
Having said that, lenders evaluate potential borrowers based on their capacity to repay the loan at the highest interest rate. Make sure the mortgage is still something you can afford over the long term; lenders can assist you in doing the math and ensuring the loan is comfortably within your means.
It’s also important to make sure the math adds up to make this a deal by carefully reviewing all the conditions, charges, and discounts.
“Is the total interest rate competitive with those offered by other lenders? If so, Lewis notes that sometimes a good deal is just a good deal and there are no hidden fees. “It would be worthwhile to examine other choices if the interest rate isn’t competitive.”
Buy-down vs. ARM: Which is better?
If you’re a home buyer considering a buy-down, you might be wondering how it compares to other loans that offer a momentary interest decrease, such as an adjustable-rate mortgage, or ARM. Although an ARM may offer a lower rate for a set amount of time (often five years), after that the price may grow quickly and annually, making it an unpredictably dangerous alternative that many people may decide to avoid.
In contrast, a rate buy-down enables borrowers to obtain a fixed-rate mortgage so they will know their payments for the next 30 years. Homebuyers who know they’ll move before the rate changes might benefit from an ARM, but those who want to stay put after that may prefer the predictability of a buy-down.
According to Nicole Rueth, senior vice president at The Rueth Team in Denver, “these plans give you the stability of having a 30-year fixed payment while having the short-term lower rate benefit [similar to] an adjustable-rate mortgage.”
Lisa Marie Conklin has some experience with relocation. In the last ten years, she has relocated eight times, but she currently counts Baltimore as her home. She contributes articles to MSN, The Healthy, Family Handyman, Reader’s Digest, and Taste of Home.
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