Rate buydowns explained: Are they worth it for your homebuyers?

In October, I wrote about debt in real estate and answered a question about mortgage rate buydowns, and I got quite a few questions about what buydowns are and what they do. So here we are this week with more info about buydowns. 

Mortgage rate buydowns explained

A buydown is an upfront payment at closing that buys a lower interest rate, and it comes in two forms: temporary and permanent. Buyers, sellers, builders and lenders can all pay for one. Fannie Mae permits buydown funds from an interested party to the sale or from the lender itself.

Temporary

Temporary buydowns, commonly called 2/1 buydowns, prepay the buyer’s interest for two years, at 2 percentage points below the note in Year 1 and 1 point below in Year 2, with the money held in a custodial account — a specialized escrow akin to an impound account but separate — and drawn down monthly. When the term is up, or money runs out, the payment snaps back to the full note rate.

Permanent

A permanent buydown, called discount points, lasts the entire life of the loan. One point usually costs 1 percent of the loan amount, and though the Consumer Financial Protection Bureau (CFPB) is clear that there is no fixed rate reduction for a point, one buydown point usually is equal to approximately 25 basis points (0.25 percent) off the loan’s rate.

Points are paid at closing by whoever agrees to pay them, and unlike the 2/1, this buydown is permanent. What changes is the arithmetic: cash now against a smaller payment for 30 years, which only pays off if you keep the loan long enough.

Wait what?

None of this is new. The Federal Reserve Bank of San Francisco (where I live) wrote about buydowns in 1983 and estimated that two-thirds of homebuilders offered buydowns on new homes in 1981 and 1982, and that about 60 percent of existing-home sales that year involved some form of creative financing.

As rates dropped, so did the need for creative financing, and by the time I started in the early 2000s (aughts … lol), they were something people rarely spoke about. They became ever rarer over the past 20 years.

Hold that next to today, when 44.7 percent of August sales nationally carried a seller concession. And seller concessions can be anything right now: price reductions, crediting non-recurring closing costs (NRCCs), origination points, etc. 

Buydowns are rare in existing residential transactions because most of us, meaning me, haven’t had to use the tool. However, Redfin agents reported that builders this year offered $10,000 to $20,000 in concessions and bought down rates to clear standing inventory.

Here are a few questions I am getting. Send yours to me here.

 Question: My buyer was waiting for prices to stabilize, and now the rates have gone up, which is incredibly frustrating for all of us. What is a mortgage buydown, and can I ask for one, or do I need to wait for a seller to offer one?

Answer: A mortgage buydown is money paid upfront to reduce the buyer’s interest rate. It can be temporary, such as a 2-1 buydown that lowers the rate during the first two years, or permanent, where discount points reduce the rate for the life of the loan. It is classified as a non-recurring closing cost.

Yes, you need to ask for a buydown and can do it in a couple of places. 

• The initial offer: This is common with new construction and with stagnant existing inventory. Write into the original offer a seller concession request to be used for NRCCs (non-recurring closing costs). There are rules around the amount of allowable concessions — maximum interested party contributions — based on the buyer’s loan-to-value.
• During the contingency period: Ask for seller concessions to cover necessary repairs discovered during the inspection contingency period. During the loan contingency period, if the buyer is no longer able to qualify for the original loan using NRCCs to buy discount points, which permanently drop the interest rate, that may keep the deal alive. 

The seller may prefer a buydown over a price reduction because it helps the buyer’s monthly payment without changing the list price. The buyer may prefer it because a lower interest rate can make a significant impact on monthly payment versus a price reduction when inflation is a factor.

Question: How much do buydowns cost and what do I get for the money?

Answer: Temporary buydowns cost the amount needed to subsidize the buyer’s payment during the reduced-rate period. Permanent buydowns, or discount points, cost 1 percent of the loan amount per point.

Here is an example using a $500,000 loan at 7 percent.

The regular principal-and-interest payment is approximately $3,327 per month. With a 2-1 temporary buydown, the rate would be approximately 5 percent during Year 1 and 6 percent during Year 2.

At 5 percent, the payment is approximately $2,684, creating monthly savings of about $643. During Year 1, that equals roughly $7,700.

At 6 percent, the payment is approximately $2,998, creating monthly savings of about $329. During Year 2, that equals roughly $3,950.

The total temporary buydown cost would be approximately $11,650, before taxes, insurance and other loan details. The loan steps up to the full 7 percent payment in Year 3. 

A permanent buydown works differently. One point on a $500,000 loan costs $5,000, but the rate reduction varies by lender and market. Consumer Financial Protection Bureau states a general rule of thumb is that 1 point equals 25 basis points, or a 0.25 percent permanent reduction from the original note rate.

The question is whether the payment savings justify the upfront cost. A lower payment is useful; ask a lender to show you the breakeven analysis.

Each week in America Answers, Inman contributor America Foy answers questions from the industry at large and offers advice on how to handle the situation.