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Buying down your mortgage rate: It’s not just one way or the other

Permanent and temporary options come with variables that complicate this tactic for cutting the cost of borrowing

8 min

For years after the Great Recession, mortgage interest rates hovered at historically low levels, and home buyers became accustomed to borrowing at less than 4 percent — and sometimes less than 3 percent. But in spring 2022, rates began to rise, and once they hit 6 or even 7 percent, buyers stepped up the search for ways to reduce them.

“Buy-downs,” which reduce mortgage interest in exchange for upfront fees, quickly became popular for buyers, especially when sellers were willing to pay the upfront fees as an incentive to buyers in a slower market.

We asked Isabel Barrow, a certified financial planner with Edelman Financial Engines in Alexandria, Va., and Dan Hanson, executive director in market retail at loanDepot in Corona del Mar, Calif., for their insights into how a mortgage buy-down works and when it might be a good option. Text has been edited for clarity and space.

Q: What is a buy-down?

Hanson: Rate buy-downs allow home buyers to reduce the interest rates on a mortgage by paying points upfront. There are two types — temporary and permanent. Temporary buy-downs offer you lower interest rates for an annual predetermined period such as one, two or three years. A permanent buy-down reduces your interest rate for the full term of the loan.

Q: How does a temporary buy-down work?

Hanson: A “3-2-1” buy-down for a $400,000 mortgage at 6 percent costs approximately $18,000. Your first-year rate would be 3 percent [or down three points], second year 4 percent [down two points], third year 5 percent [down one point], and the fourth year through the remainder of your mortgage would return to 6 percent. You would save $732 per month the first year, $502 monthly the second year and $257 per month the third year.

Temporary buy-downs can be paid by the buyer, seller or a third party such as a lender. Historically, builders have paid for buy-downs as a tool for selling new construction homes, and they have been gaining popularity for sellers as the resale market continues to soften.

Costs for a temporary buy-down vary based on market conditions and the type of buy-down. Typically, one point will cost one percent of the loan amount, so if your loan is $400,000, one point would cost $4,000. For “1-0” buy-downs, you’re buying one point for one year, for “2-1” buy-downs you’re buying three points and for “3-2-1” buy-downs you’d typically buy six points. Temporary buy-downs tend to be much cheaper than a permanent buy-down.

For temporary buy-downs, you must qualify for the loan at the permanent [or final] rate of the mortgage [after the buy-down ends].

Q: How does a permanent buy-down work?

Hanson: A permanent buy-down lowers the interest rate for the entire life of the loan, so you qualify based on the final rate. Permanent buy-downs, which are available on most loans, are typically paid by the borrower, though sometimes home builders will contribute. A home buyer pays a certain number of “points” upfront to pay a lower interest rate over the life of the loan. Typically, home buyers will pay one point for a 0.25 percent reduction in their rate, but this varies based on interest rates and market conditions.

For example, on a $400,000 loan with a 7.375 percent rate, your monthly principal and interest payment would be $2,763. For approximately $8,000, you could lower your rate to 6.5 percent and save $234 per month for the entire loan term. Your $8,000 payment would be recouped in 2.7 years based on the monthly savings.

Q: What circumstances make a buy-down a good decision for a buyer?

Barrow: If you’re planning to be in the home for the long term and it’s a permanent buy-down, this can be a good decision. The longer you plan to stay in the home, the better the chances are that buying down the mortgage is financially beneficial. However, if you expect interest rates to go down in the future, you may not need a buy-down, as you’ll have the option to refinance instead down the road.

To know if a buy-down makes sense, you need to determine your break-even point, which is how long you have to hold the loan to make it worth it to pay these points. For example, if the lower rate saves you $100 per month and the cost to buy down the loan is $1,200, your break-even is one year. If you hold the loan for longer than a year, you save $100 per month for the remainder of the loan term. In this example, buying down the rate makes sense if you plan to be in the home for more than a year.

To manage the risk that rates don’t go down and you can’t refinance, a mortgage rate buy-down might be smart in terms of overall savings for the life of the loan.

Hanson: Seller- and third-party-paid temporary buy-downs can provide you with more buying power. You also get an added level of comfort knowing you’ll have more cash available in your monthly budget to cover typical expenses and some of the costs that come with owning a new home, such as new furniture and unexpected repairs.

A temporary buy-down may also make sense if you expect your income to increase over time. The buy-down allows you to pay a lower interest rate to start, then you’ll be able to afford the higher rates since your income will rise as your loan adjusts.

With a permanent buy-down, you should think about how long it will take to get to the break-even point and ask yourself if you’d rather have less cash in the bank now and a lower monthly payment or more cash in the bank and a higher payment.

Q: What are the pros and cons of a temporary rate buy-down vs. a permanent buy-down?

Barrow: With a temporary buy-down, you’re really just paying upfront in exchange for a lower payment for a couple of years. In most cases this doesn’t make sense, unless the buy-down is paid by the builder or the seller, which is more apt to happen in a buyer’s market. If you expect your income to go up during the buy-down phase, then this may make sense. My concern would be that you get into a home that you can afford initially, but once the buy-down period is over, you may be in a situation where your monthly payment is more than you can comfortably afford.

A permanent buy-down makes more sense if you plan to be in the home for a long time or you expect interest rates to stay high for the foreseeable future, meaning you won’t have an opportunity to refinance to a lower rate anytime soon.

Q: What are the downsides to a buy-down?

Barrow: The primary downside to a buy-down is the upfront cost and the lost opportunity cost. For example, if you spend $20,000 upfront to buy down your loan, what risks are you taking? What would that same $20,000 be doing if otherwise invested, and not paid upfront to the mortgage lender? Would you be investing that money for the long term, and could it earn more over the long term than you’re saving in rate adjustment? What if interest rates go lower in the future and you decide to refinance? Was it worth it to pay for the lower rate upfront when you may end up with an even lower rate option in the future?

Q: How does a buy-down compare with other options, such as making a bigger down payment or getting an adjustable-rate mortgage?

Barrow: Making a bigger down payment, especially if you can get to 20 percent, can help bring your rate down since many lenders will use that benchmark to determine your rate. You’ll also avoid paying private mortgage insurance with a 20 percent down payment. Additionally, a larger down payment has the net effect of a smaller monthly payment and less interest over the life of the loan. However, given the 30-year time, this may feel like a smaller benefit in the beginning, as it takes 30 years to feel the full benefit of the savings.

Another tempting option for buyers is an adjustable-rate mortgage (ARM). Typically, an ARM has a lower rate than the average 30-year loan for an initial period, typically three, five or seven years, and will then fluctuate with the going rate. The problem with an ARM is that typically when the rate goes up, this makes the monthly payment jump up, sometimes dramatically.

While this option may be interesting for someone with a shorter time frame in the home, I would argue buying is too costly if you plan to own for only a short period of time. And if you plan to refinance before the rate jumps up after the term, what if rates are higher than they are now? Interest rate changes are notoriously hard to predict in the short term, much less the long term. Taking that much risk on something as important as your home is likely too much for most buyers.