Some prospective homeowners fixate on getting the lowest interest rate, even if they have to put up more money at closing. This group of buyers may opt for a buy down mortgage, where they pay one-time feeds for lower interest rates.
Some buy down mortgages are seller financed, but the seller typically charges a higher sales price in exchange for funding a lower interest rate at closing.
In order to reap the benefits of this type of loan, you should plan to spend several years in the home since the savings in interest rates won’t be realized right away.
Types of Buy Down Mortgages
The most typical buy down mortgages are known as 3-2-1 and 2-1 buydowns.
The 3-2-1 buy downs impact 30-year mortgages. In the first three years, the mortgage interest rate increases by 1 percent. For instance, a 3.75% percent interest rate increases to 4.75% in the second and to 5.75% the third year.
After three years, the interest rate is frozen at 6.75 percent for the life of the mortgage. The 3-2-1 buydown is ideal for low-income borrowers with extra cash for closing.
It works in much the same way as buying points to get a lower interest rate. Lenders typically request a higher down payment when a 3-2-1 buy down is requested.
The 2-1 buydown also applies to 30-year mortgages. In this case, the initial rate can only go up for two years before staying at a fixed rate for the remainder of the loan term (28 years). Such buydowns typically require a lower down payment.
Advantages of Buy Down Mortgages
Buydowns often work as a mortgage subsidy on behalf of the seller.
- The seller may contribute money to the closing escrow account. This money is used to subsidize the interest for the first two or three years. The advantage to the homebuyer is a lower monthly payment.
- With a lower payment, the homebuyer is more likely to qualify for the mortgage.
- The advantage to builders or sellers comes in making properties more affordable to buyers, which can result in quicker sales.
It’s important to carefully review all the terms of the mortgage. Make sure you can afford the fixed rate that locks in at the end of the 3-2-1 or 2-1 period.
Example of a Mortgage Buydown
Here’s an example of how a 3-2-1 buy down might work for a 30-year mortgage.
- The interest rate goes up 1% each year for three years
- After three years, the new rate is fixed for the life of the mortgage.
Assume you have a loan balance of $350,000 with a fixed interest of 6.75%. You or the seller could buy down the interest rate with a lump sum of $15,853. Here’s what your monthly payment would look like:
- Year 1: interest rate = 3.75%, payment = $1,621 per month
- Year 2: interest rate = 4.75%, payment = $1,826 per month.
- Year 3: interest rate = 5.75%, payment = $2,043 per month.
- Year 4 to 30: interest rate = 6.75%, payment = $2,270 per month.
- The first year’s savings is $2,270 – $1,621 per month or $649 per month and $7,790 for the year.
- The second year’s savings is $2,270 -$1,826 per month or $444 per month and $6,332.
- The third year’s savings is $2,270 – $2,043 per month or $228 per month and $2,731.
The total savings = $7,790 + $6,332 + $2,731 = $15,853. This is what it costs to buy down the interest for the first three years.
Take to your lender to see which buy down mortgage would work best for your family.