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Interest Rate Buydowns

10/24/2022

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​Interest rates have risen, putting a squeeze on buyers. In a rising interest rate environment, alternative mortgage programs start looking very attractive.  The 2-1 interest rate buydown and the 1-0 interest rate buydown are getting a lot of interest.
 
What Is An Interest Rate Buydown?
A temporary buy-down is a cash payment that effectively lowers the borrower’s interest rate for a limited period, allowing borrowers to reduce their monthly payments during the early years of the mortgage. The party providing the buy-down funds will normally make a lump-sum payment into an escrow account at closing. The borrower pays a monthly payment based on the reduced or “bought down” rate and the funds from the escrow account are used to make up the difference to the lender.
Typically, the payment of discount points reduces the interest rate for the first few years of the loan. For example, if the interest rate is 7% and a 2-1 buydown has been purchased, the buyer would pay interest at the rate of 5% for the first year, 6% for the second year and 7% for the remainder of the loan.  A 1-0 buydown would start at 6%. A loan can also be bought down for the life of the loan. It is more expensive, of course, but the buydown fee can be justified if the buyers expect to be living in the property for a long time.
​How Much Does A Discount Point Cost?
Each discount point is equivalent to 1% of the loan amount.  These are approximate examples:
  • 1-0 Buydown. To reduce a $400,000 mortgage from 7% to 6%, the cost would be 1% of the mortgage or approximately $4,000. 
  • 2-1 Buydown. Reducing from 7% to 5% would cost approximately $8,000 for the first year and $4,000 for the 2nd year.  So, the 2-1 buydown from a 7% mortgage would cost $8,000 plus $4,000 or $12,000. 
The calculation used to buy down the rate may also differ among lenders but is usually about equal to what the borrower saves in interest.
 
Who Pays the Cost of a Buydown?
Typically, builders are the most likely to buy down a rate as an incentive to purchase their new homes. However, to make up for this expense, the builder will typically add at least some of the cost to the purchase price of their home. If resellers are paying for the buydown, they will typically add most of the cost to the purchase price, particularly in a seller’s market.  In those cases, watch out for the appraisal and the seller contribution that a lender will allow a seller to pay. 
 
The Buyer Must Qualify On The Note Rate.Fannie Mae, Freddie Mac and the Federal Housing Administration require the borrower to qualify at the note rate. If the borrower needs a lower interest rate to qualify for the loan, Veterans Affairs will allow the borrower to qualify based on the first year’s payment if the borrower’s income is expected to increase. Expectations of increased income include confirmed future promotions or wage percentage increases guaranteed by labor contracts.
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