In the current economic climate, rising interest rates are one of the most significant barriers to home buying. Current interest rates are higher than they have been in decades, putting major financial roadblocks in the way of individuals who want to buy a home.
Many potential solutions exist to help you get an affordable interest rate that would allow you to buy the home of your dreams. One such example is a mortgage rate buydown. Unsure of what a buydown mortgage is? Read on for more information and how this financial maneuver can help make your mortgage more affordable.
What is a Mortgage Rate Buydown?
Simply put, a mortgage rate buydown allows you to reduce the interest rate on your mortgage. You do this by paying extra points–also known as discount points—on your mortgage when you first take the loan out, meaning you pay more upfront. In doing so, you can reduce the interest you pay toward your mortgage, potentially allowing you to find massive savings over the length of your loan.
A mortgage rate buydown is more worth it in some situations than others. Individuals struggling to make a down payment may find that they do not have the money to buy down their mortgage interest rate, as they simply will not have achieved the savings necessary to purchase discount points. However, individuals who have achieved adequate savings may find this expense well worth it, as an investment in discount points can result in significant savings over the life of the loan.
These tools have been more used today than ever before. The reason is simple: Interest rates have risen significantly since the Fed began hiking rates to try and slow inflation. As of this writing, interest rates are higher than in roughly twenty years.
An Example of a Mortgage Buydown
Considering that one discount point costs 1% of the total loan amount, the overall expense for discount points is directly tied to the loan amount you decide to borrow. A discount point represents a prepaid interest fee, paid one time and upfront, which is deducted from your loan.
Consider the following example. Suppose you are taking out a loan on a $1,000,000 property. In this instance, the borrower may be willing to reduce your 30-year fixed mortgage loan by .25% for every point you purchase. Current interest rates are roughly 8%, and one point will cost you $10,000. As such, if you purchased four points, you’d pay $40,000, and your interest rate would decrease to 7%.
By lowering the interest rate, monthly mortgage payments will be more affordable during the specified time period. This can be particularly helpful if you anticipate financial constraints or are purchasing during a period of high-interest rates.
How Are Buydowns Structured?
There are actually multiple ways to buy down mortgages. The standard way is described above. In that example, flatly purchasing points will reduce a mortgage loan for its entire lifetime. However, there are additional ways.
For example, consider a 3-2-1 buydown mortgage. In this method, the seller, homebuilder, or lender will cover the cost of buying the points, enabling the homebuyer to reduce their interest rates. The rates will reduce by 3% in the first year, 2% in the second year, and 1% in the third year. In the fourth year, interest rates return to normal.
There is also a 2-1 buydown mortgage. This technique is a “lighter” form of the 3-2-1 buydown mortgage, as rates reduce by 2% in the first year and 1% in the second year.
3-2-1 and 2-1 buydown mortgages have become more popular today, as they can provide incentives for homebuyers who want to buy a home but may worry about current interest rates. In this method, an individual can reduce interest rates – even temporarily – before rates return to their full price. Furthermore, there is nothing that would stop an individual from refinancing their interest rate when the 3-2-1 or 2-1 mortgage expires. As such, it is possible that an individual would be able to take advantage of lower interest rates through refinancing. From the seller or lender side, 3-2-1 or 2-1 buydown mortgages can be an excellent incentive to close a sale, particularly during high-interest rates.
However, individuals who take advantage of either form of these buydowns must prepare for the spike in interest rates. They must also ensure they have the income to afford such a spike and thus work with a lender to plan their finances appropriately.
Final Thoughts
A mortgage rate buydown can be an excellent tool that allows an individual with a high net worth to reduce the interest rate they pay over the life of a mortgage loan. Alternatively, a 3-2-1 buydown mortgage or 2-1 buydown mortgage can be effective, but it requires appropriate planning for when interest rates rise again.
