(NewsNation) — As interest rates continue to cut into housing affordability, industry experts say mortgage buydowns have become more common over the past year.
“We definitely saw an uptick in 2022, throughout the year, from beginning to end,” said David Battany, an executive vice president at Guild Mortgage.
Buydowns are a way for buyers to pay a lower interest rate, either temporarily or permanently, because a mortgage lender has received additional money up front, effectively “buying down” the rate.
In today’s market, many sellers and homebuilders are funding buydowns themselves in order to attract buyers.
What is it?
A buydown is a mortgage-financing technique where a buyer pays a lower interest rate either in the first few years of a mortgage loan (temporary) or over the lifetime of the loan (permanent).
In order to obtain the lower rate, one of the involved parties pays extra cash upfront to buy down the interest rate.
In a high-interest rate environment where fewer people are buying homes, sellers and homebuilders may offer buydowns as a way to close the deal.
How do they work?
A permanent buydown is exactly what it sounds like — a reduction in the interest rate over the full life of the loan. Think of it like prepaid interest, which could be paid for by the borrower or the seller. The lender gets more money up front and reduces the interest rate over the course of the loan.
A temporary rate buydown, by comparison, lowers the interest rate, but only for a short period of time before returning to the fixed rate.
For example, a 3-2-1 rate buydown would lower the homebuyer’s interest rate for the first three years and gradually increase over the period. The interest rate is reduced 3% in the first year of the loan, 2% in the second and 1% in the third.
Another common buydown is the 2-1 format, which lowers the interest rate on a mortgage for the first two years.
Again, the temporary rate reductions are paid for by buying down the interest rate. That funding, which may be provided by a seller or builder, is usually kept in an escrow account. Any leftover money, which could result from selling or refinancing the home, goes to the buyer.
What’s the benefit?
With mortgage rates currently hovering around 6-7%, a temporary buydown may delay full interest payments long enough for buyers to refinance at a lower rate down the line, and, in effect, avoid current rates entirely.
“I’ll be able to refinance, hopefully, get lower than 6% and I’ll never even have to pay that 6% rate,” said Steve Hill, a California-based mortgage broker at SBC Lending. “That’s how a lot of homebuyers are thinking.”
For sellers and builders looking to make an offer more attractive, buydowns can help close the deal. Hill said he has noticed home sellers using temporary buydowns more recently.
They can also be a good option for homebuyers looking to protect their cash reserves, which may have been diluted by the down payment.
If a buyer expects their income to increase after the first few years of buying a home, a buydown can temporarily ease the monthly interest payment until the owner is in a more comfortable position to pay the full amount.
“It’s really about, what you can do to help the borrower in those first five years when their cash position is thinner, their income has not gone up yet and they’re more financially vulnerable to a life curveball,” Battany said.
Who pays for the buydown?
Borrowers, lenders, sellers and builders all use buydowns as a way to temporarily, or permanently, lower the monthly interest payment on a mortgage loan.
Recent surveys show homebuilders are using buydowns to attract buyers in today’s market.
For example, 75% of builders surveyed by John Burns Real Estate Consulting in December said they were paying to reduce buyers’ mortgage rates in order to make payments more affordable.
About 32% of builders said they’re buying down the full 30-year term, while 30% are opting for temporary buydowns, which can cost them anywhere between $6,000 and $48,000.
Are there risks?
Borrowers have to qualify for the full monthly rate before the buydown adjustment is factored in to ensure they aren’t being approved for loans they can’t afford, Battany pointed out.
Depending on who’s funding the buydown, there are pros and cons.
Paying more cash up front to permanently reduce the rate of the loan is more likely to be in a homebuyer’s interest if they plan to keep the property for a long time. If not, it’s possible they’re better off saving the cash and paying the higher rate.
Temporary buydowns can also present a challenge if a homebuyer is counting on refinancing at a lower rate but rates don’t come down. But unlike an adjustable rate mortgage, which can be more vulnerable to rising mortgage rates, temporary buydowns are still capped at the fixed rate even after the reduced period ends.