DEALING WITH HIGHER MORTGAGE RATES

During the last run up of interest rates in the late 80’s and 90’s a Buyer would negotiate with Seller to pay towards buyers INTEREST RATE BUY DOWN with an acceptable offer. During the 80’s and 90’s to deal with high interest rates banks developed 3 particular options as tools to help home buyers which we are seeing starting to come back today. The option you choose should depend on whether you think interest rates will come down again in the short term or not. If you are very conservative and feel they will not, option 3 may be your best bet. Since interest rates have recently gone up, it is a good guess that they will not come down very soon. This is why you may want to be conservative and go with option 3. The other consideration is how long you would expect to live in the home. If 3 to 5 years, then look at option 1 and 2. Read below for great information on how finance options could help you. Included are terms and methods below.

WHAT IS A BUY DOWN?

A buydown is a way for a borrower to obtain a lower interest rate by paying discount points at closing. Discount points, also referred to as mortgage points or prepaid interest points, are a one-time fee paid upfront. In the case of discount points, the interest rate is lower for the loan term.

In an alternate form of buydown, the points purchased reduce the interest rate for the first few years of the loan. This arrangement is typically paid for through funds escrowed by the seller. Since the interest rate is lower during this time, the borrower’s monthly mortgage payments are less.

Because mortgage rates are forecasted to continue rising in 2022, the buydown method can be a useful tactic to use with rising rates.

HOW MUCH DOES IS COST TO BUY DOWN AN INTEREST RATE?

The cost for each discount point depends entirely on the amount you, as the borrower, take out on the loan. Each point that a borrower pays is equivalent to 1% of the loan amount.

For example, a mortgage lender may offer a borrower the ability to reduce their interest rate by .25% in exchange for a point. So, if the borrower is obtaining a mortgage for $400,000 and is offered an interest rate of 5.75%, paying $4,000 would lower their interest rate to 5.5%.

Mortgage at $400k (Chart) Assumes 5.75% 30 year loan. See estimates. 

$4,000 = 5.5%

$8,000 = 5.25%

$12,000 = 5%

$16,000 = 4.75%

 

WHO CAN BUY DOWN A MORTGAGE?

Although it’s the buyer (or borrower) who benefits from a buydown, the buyer isn’t always the one who buys down a mortgage. Sellers and builders can offer to pay points to lower the buyer’s interest rate.

Buyers

The majority of buydowns are negotiated between buyers and lenders. Home buyers offer to pay a specific number of points upfront, and in return, they receive a lower interest rate, making their mortgage more affordable for a certain number of years or over the loan term, depending on the buydown structure.

Sellers

Sellers may also offer to buydown a buyer’s mortgage to incentivize the buyer to purchase their home. In these circumstances, the seller will make the one-time payment and deposit into an escrow account as part of seller concessions.

This payment, or subsidy, provides the lender with the funds necessary to lower the buyer’s interest rate so that the buyer can more easily afford their home loan monthly payment. However, to make up for this expense, especially in a seller’s market, the seller often will add the cost of the subsidy to the purchase price of their home. In a buyers market it may simply be part of a buyers demand of seller.

HOW BUY DOWNS ARE STRUCTURED

Since buydowns are negotiated, they can be arranged in a variety of ways. In addition to buydowns over the life of the loan, common structures that lenders use are the 3-2-1 buydown and the 2-1 buydown. However, regardless of the structure, the principles are the same.

The buyer, seller or builder will pay the lender the difference between the standard interest rate and the lowered rate through points at closing. The buyer will benefit from the reduced interest rate until the buydown expires, usually after a few years. Not all buydowns expire. If it does, the buyer will have to pay the standard interest rate for the remainder of the term, which will cause their monthly mortgage payments to increase.

OPTION 1 |  3-2-1 BUYDOWN

A 3-2-1 buydown enables a buyer to pay less interest on their mortgage for 3 years after obtaining the loan. The points paid upfront reduce the interest rate by 1% for each of those first 3 years.

Let’s say a buyer wants to borrow $400,000 and qualifies for a 30-year fully amortized mortgage at an interest rate of 5%. The buyer decides they want to lower their interest rate for the first 3 years with a 3-2-1 buydown. In this scenario, the buyer would pay an interest rate of 2% the first year, 3% the second year and 4% the third year but would have to pay the full 5% from years 4 – 30.

Review the chart below to see how the buydown would affect the buyer’s monthly mortgage payments.

Year        Interest Rate     Payment     Monthly Savings    Annual  Savings

1                2%                $1,478.48         $668.81               $8,025.70

2                3%                $1,686.42         $460.87               $5,530.44

3                 4%               $1,909.66         $237.63              $2,851.50

4 – 30        5%                $2,147.29               $0                        $0

While the number of points charged for the buydown differs among lenders, the cost of the buydown is usually roughly equal to the amount the buyer would save in interest. In this case, the total cost of the buydown would be around $16,400.

OPTION 2 |  2-1 BUYDOWN

The 2-1 buydown also provides a buyer with a discounted interest rate, but only for the first 2 years of the loan’s term. With this option, the interest rate would be 2% lower the first year and 1% lower the second.

Based on the previous example of a $400,000 30-year loan with a standard interest rate of 5%, the buyer would be expected to pay an interest rate of 3% the first year, 4% the second year and 5% from years 3 – 30.

Year        Interest Rate    Payment       Monthly Savings   Annual  Savings

1                 3%              $1,686.42           $460.87             $5,530.44

2                 4%              $1,909.66            $237.63            $2,851.50

3 – 30         5%                  $2,147.29            $0                       $0

The buyer would save approximately $8,380 in interest, so the buyer should expect the total cost of the 2-1 buydown to be in that same ballpark.

OPTION 3 |   EVENLY DISTRIBUTED INTEREST RATE REDUCTION

If you think you are going to live in your desired home long term, you may choose to purchase enough discount points to reduce the interest rate evenly over the life of the loan. By obtaining a buydown loan, the buyer or combo buyer & seller pay an even larger sum upfront that prevents their interest rate and thus their monthly mortgage payments from ever increasing.

Using the same example as above, the buyer would be expected to pay a monthly mortgage payment of $2,147.29 for a zero-point loan, which is a loan without any discount points applied. If the buyer decides they’d rather buy down the mortgage and pay 4% interest throughout the loan’s term, their payments will look like this:

Year       Interest Rate   Payment     Monthly Savings    Annual Savings

1 – 30         4%            $1,909.66       $237.63                 $2,851.50

Since the buyer would be lowering their interest payments for the entire life of the loan – instead of just 2 or 3 years – the total cost of the buydown would be higher. These buydowns usually cost around $16,000 – $20,000 – and save buyers somewhere around $85,550 – but they only make sense for buyers who intend to stay in the home for more than 5 years or so.

In business and in your home, finance is one of the keys to success. This is why your lender is a key partner in your home purchase success. Be sure to discuss all your options with a lender and have them clarify options like these that may work for you.

BEN AMANTE

My goal is to help people move forward. Buying or selling a home is one of life’s big moves regardless if it is your first time or 10th time. My goal is not to just sell a house or find a house. I aim to help sellers achieve the greatest value for their most coveted possession, their home. For buyers, I want to find them the house they want, in the place they want to be and I want it to be the somewhere they feel good about calling home.

Skip to content