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How does a mortgage rate buy-down work?

A temporary buy-down provided by the seller allows the borrower to have more money available during the early years to handle furnishing and renovation costs. (Jim Lo Scalzo/EPA-EFE/Shutterstock)

Higher mortgage rates — up nearly double over a year ago — cut into affordability and increase monthly payments for buyers.

Rising rates are particularly challenging for buyers who may be struggling to afford their first home or those who hope to move up into a larger and more expensive property. While there are multiple strategies to manage higher mortgage rates, one option to consider if you have some extra cash is to buy down the interest rate temporarily.

We asked for advice about this strategy from Peter Idziak, an attorney based in Dallas at residential mortgage law firm Polunsky Beitel Green; David Cox, a sales manager and senior loan originator in Boulder, Colo., with Cherry Creek Mortgage; and Karla Melgar, a senior loan officer in La Plata, Md., with Embrace Home Loans, which is based in Middletown, R.I. All three answered by email and their responses were edited.

What is a buy-down and how does it work?

Idziak: 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.

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Although a party can agree to buy down the rate by any amount and for any length of time, the most common buy-down agreement calls for the interest rate to be reduced by a certain number of whole percentage points (i.e., reduced from 5 percent to 3 percent) and then increase 1 percent per year until it reaches the undiscounted note rate.

Melgar: A buy-down is a mortgage financing technique in which the buyer obtains a lower interest rate for the first few years of the mortgage. It is a way for a borrower to obtain a lower interest rate by paying extra cash at closing so their monthly payment is based on an interest rate that is typically 1 percent to 2 percent below the note rate. The first-year rate on a buy-down is often referred to as the “start rate.”

For example, the interest rate on a 2-1 buy-down would be 2 percent below the note rate for the first year and 1 percent below the note rate for the second. Then years three through 30 would be at the note rate.

How much does a buy-down usually cost?

Idziak: The cost to temporarily buy down the interest rate will depend on the size of the mortgage loan and the amount and duration of the buy-down. 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. As an example, using the average mortgage ($415,000) with a 30-year term, a 2-1 buy-down would cost approximately $9,000 and a 3-2-1 buy-down would cost around $17,000.

Cox: For a buyer who makes a down payment of 20 percent, the cost to fund the escrow or buy-down account for a 2-1 buy down is about 2 percent of the purchase price or about 1.7 percent of their loan amount. The dollar amount required to fund the buy-down account is a calculated amount needed to supplement the buyer’s discounted payment over the two-year period.

Who usually pays for a buy-down?

Cox: The escrow or buy-down account can be funded by the seller, the buyer, the lender or a third party, such as a Realtor. Getting the seller to accept a concession to fund the account is usually the most beneficial scenario for the buyer.

Melgar: A buy-down can be paid by the buyer, seller, mortgage lender or builder. In my experience, buy-downs are most often used in new home construction and the builder typically pays for it.

What is the benefit of a buy-down?

Idziak: Home affordability concerns are at the forefront of many buyers’ minds in the current environment. The first few years of homeownership are often the most expensive, especially for first-time buyers. Furnishing a home and completing renovations or upgrades are often major expenses for buyers. A temporary buydown provided by the seller allows the borrower to have more money available during these years to handle such costs.

Borrowers often expect their incomes to increase in the future. Lower monthly payments during the first few years of a mortgage can allow a buyer time to adjust to what, for most, will be a higher monthly housing expense. For buyers who qualify for a mortgage but may be worried about their short-term financial picture, a temporary buy-down may give them the confidence to take out a mortgage and purchase the home.

How does a buy-down impact a loan qualification? Is the buyer qualified on the lower rate or the later rate?

Idziak: 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 there are “strong indications” the borrower’s income will increase to cover the yearly increases in loan payments. Such strong indications include confirmed future promotions or wage percentage increases guaranteed by labor contracts.

It’s important to note that under the federal Ability to Repay Rule, most lenders are required to make a reasonable and good faith determination that the borrower has the ability to repay the loan using the borrower’s monthly payment without considering the temporary buy-down. This requirement helps prevent past abuses of using introductory or “teaser” rates to qualify a borrower who would not have qualified for the mortgage using the permanent interest rate.

What are the advantages of doing a buy-down rather than making a bigger down payment?

Idziak: For borrowers who may not plan to be in the home more than a few years — or who expect rates to go down and to refinance in the near future — using a seller concession to purchase a temporary buy-down can result in greater savings to the borrower compared to using funds to make a larger down payment or to buy points to permanently bring down the interest rate. As noted above, for borrowers who expect to have a higher income in the future, using their funds or seller concessions to concentrate the benefits in the first few years of the mortgage when money may be tightest can be a savvy financial planning tool.

Cox: Compared to a larger down payment or even paying discount points [which are equal to 1 percent of the loan amount] to permanently buy down the interest rate, the 2-1 buy-down yields a much shorter break-even point. For example, at current interest rates, a larger down payment will only impact the monthly payment by about $5.40 for every $1,000 or about $54 a month for an extra $10,000 down payment. For a 2-1 buy-down scenario in which the purchase price is $600,000 with 20 percent down and $10,000 is put toward the buy-down, the buyer’s payment would be reduced by $550 a month during the first year and $285 a month the second year.

Melgar: The buy-down will sometimes allow the purchaser to consider a larger home, especially for first-time home buyers who anticipate a growing family. This type of loan is also popular with buyers who know their income will increase over the next two to three years.

What are the disadvantages of doing a buy-down rather than making a bigger down payment or paying discount points for the loan?

Idziak: Buyers who plan to own the home for a significant length of time may benefit more from a lower monthly payment over the life of the loan, as opposed to a temporary reduction in payments over the first few years of the loan. For such buyers, using those funds to buy points to permanently reduce the interest rate or toward a larger down payment may result in greater savings over the life of the loan. Additionally, borrowers putting less than 20 percent down on a conventional purchase are normally required to purchase mortgage insurance. The cost of such insurance over the life of the loan could outweigh any benefit a borrower would receive from using their funds to fund a temporary buy-down.

When to lock in your mortgage rate

Cox: A disadvantage of the buy-down is the homeowner’s payment will increase after the first and second year before stabilizing in the third year going forward, so eventually they will have to adjust their monthly budget for those larger payments.

Any other comments?

Idziak: Most conventional or government loans have limits on so-called “interested party” contributions, which are costs normally paid by the purchaser but covered by another party to the transaction. Buy-down funds provided to a borrower by another party to the transaction are included within these limits, so buyers should be aware that their lender may limit the amount of money a seller, developer, real estate agent or lender can contribute to fund a buy-down.

Cox: The 2-1 buy-down program is a phenomenal way for buyers to ease into their new mortgage payment. This program also is a great way for buyers to get into a home sooner and benefit from price appreciation immediately, rather than waiting to buy in hope that rates drop in the future. If the buyer were to sell, refinance or pay off the mortgage before the end of the second year, the remaining escrow or buy-down funds are refunded to them or applied toward the payoff of their mortgage.

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