Temporary Rate Buydowns

What is a temporary rate buydown?

A temporary rate buydown reduces the interest rate of your mortgage for a temporary period of time, hence the name! How much your rate gets reduced and for how long all depends on the type of buydown you’re doing. The most common options are a 3-2-1 buydown, a 2-1 buydown down, a 1-1 buydown or a 1-0 buydown. 

Now what do those mean? The number corresponds to the amount by which your interest rate will be reduced. So if your market interest rate is 6.5% then on a 3-2-1 buydown your rate would be reduced by 3% the first year. This would give you a 3.5% interest rate for year 1. Then the next number corresponds to how much your rate will be reduced in the following year, in this case 2%, then the following year it will be reduced by 1%.  So in year 2 the rate would go up to 4.5% and in year 3 it would go to 5.5%. Finally in year 4 it would revert back to the market rate of 6.5%.

When we use the term market rate, we mean the rate the lender is offering with no additional discount points. Your permanent rate can also be bought down as well. 

A 2-1 rate buydown is 2% lower for the first year, and then 1% lower, reverting back to the market rate in year 3.  A 1-1 buydown is exactly how it reads along with the others, 1% lower for the first and second year. Finally the 1-0 temporary buydown is just 1% lower for one year!

This can be utilized for any fixed rate term or type of financing, whether it be conventional, FHA, VA, USDA. 

How much does a temporary buydown cost?

This part takes a little work to calculate but it’s not complicated in principal. The cost of a temporary buydown is literally the amount of savings the temporary buydown will give you for the duration of the buydown period. Its that simple, but you have to do some math. 

Let’s look at an easy example to see the math. Say you have a $400,000 mortgage. Your lender is quoting you a 6.5% interest rate. You want to use seller concessions that you negotiated into your contract to buydown your interest rate with a 2-1 buydown. So the first year your interest rate will be 4.5%, and the second year it will be 5.5% and the third year it will revert back to 6.5%.

Your principal and interest payment on a 30 year mortgage at 6.5% on $400,000 is $2,528.27. The first year at 4.5% the payment will be $2,026.74. A savings of $501.53 a month, or $6,018.35 for the year.

The second year the rate goes to 5.5% and a monthly payment of $2,271.16. A monthly savings of $257.11 and a yearly savings of $3,085.37. In total the temporary savings was $9,103.72. That happens to be 2.276% of the loan amount. That is cost of your buydown. 

However seller concessions are based off of the purchase price. if you bought the house for $500,000, the cost of the buydown would be 1.821% of the purchase price. If you negotiated a 3% seller concession you still $5,895 left over to go towards your closing costs.

This same methodology is used for any type of buydown. Whether you are paying it yourself or the seller is. The same applies for a borrower paid temporary buydown when refinancing as well. 

Why would you utilize a temporary buydown and what are the risks?

This question has a bit of a subjective answer but there are a few possibilities. One possibility is that you might expect interest rates to drop in the next 2-3 years, at which point you could refinance. This could be a risky decision based on a couple of factors. One risk is that rates drop much quicker than anticipated. It takes 4 years to make up the cost in savings for a 3-2-1 buydown. If rates drop significantly 12 months after your purchase a home you now have the opportunity to refinance, but the savings of the temporary buydown basically evaporates. You didn’t make up the cost in savings because you didn’t live out the lifespan of the temporary buydown. Furthermore if you wait, you risk rates going back up.

The other risk is that rates stay higher, for longer than expected. In this case the temporary buydown was good for the duration of the buydown but those funds could have been used to permanently buy down the rate. The permanent rate reduction would not be as substantial for the cost but it would be permanent and save you more in the long run. 

However it could be that you time things perfectly, or at least close. You take advantage of a payment that is much more palatable with a temporary buydown and right when your payment would revert to the original higher amount you are able to refinance and take advantage of a permanently lower interest rate. 

There’s another reason you could utilize a temporary buydown. Maybe you only plan to live in the home for a couple of years. It could make sense. Additionally you could be expecting a large settlement and plan on paying your home off at the expiration of your temporary buydown. There are lots of reasons, risks, and potential rewards when using a temporary buydown and we are glad to assist you in assessing those reasons and risks. We are glad to accommodate any type of temporary buydown for you.