There’s no doubt that the housing market today isn’t what it was a couple of years ago. Even just one year ago, we saw astronomically low-interest rates and were living in a seller’s market.
Today, interest rates are continuously moving upward in an increasingly stagnant market, where sellers are having just as much trouble selling as buyers are having trouble pulling the trigger. This is why considering alternative financing is critical to prospective homebuyers, like opting for a 2-1 buydown.
We’ll dig into everything you need to know about a 2-1 buydown, but first, let’s talk about what it means to buy down a mortgage.
Buying Down A Mortgage
Buying down a mortgage is a financing arrangement that enables a borrower to score a lower interest rate on their loan. Thus, mortgage payments are more manageable since they’re accompanied by lower interest rates for either the first few years of the loan or the entire loan term.
To fully answer the question, “what is a buydown loan,” we need to know what discount points are and types of buydown mortgages.
Everyone loves a good discount! Well, just like a 60% off sweater on Black Friday, getting discount points on a mortgage is something you don’t want to miss out on.
Also called mortgage points, these are used to buy down the loan’s interest rate. The buyer pays discount points to the lender at closing as a one-time upfront fee. Then, the borrower will acquire a lower interest rate for a certain number of years during the loan term, depending on how many discount points they paid upfront and what buydown structure they’re working with.
Each discount point represents one percent of the original loan amount. This means that one discount point paid on a $200,000 loan would equal $2,000, two discount points would equal $4,000, and so forth. It’s important to note that while the value of a discount point is consistent among lenders, the amount that a discount point cuts down the loan’s interest rate may vary. The latter is based on current market rates and the loan type.
Types Of Buydown Mortgages
There are different types of buydown loans available to borrowers. The main way that buydown loans are differentiated is by the number of years they provide reduced interest rates. This is typically split into two categories: Permanent buydowns and temporary buydowns.
WHAT’S A PERMANENT BUYDOWN?
With a permanent buydown, the interest rate is bought down and subsequently reduced for the entire loan term. Meaning a 30-year mortgage with permanent buydown financing will come with a lower interest rate for 30 years.
WHAT’S A TEMPORARY BUYDOWN?
When a borrower decides to go for a temporary buydown, the interest rate will be lower for a specific amount of years during the loan term. With these types of financial arrangements, the interest rate is reduced for a fixed number of years, starting with the initial year of the loan term.
Two kinds of temporary buydowns are the 3-2-1 buydown and the 2-1 buydown. The former comes with reduced rates for the first three years of the loan, and the latter comes with reduced rates for the first two years of the loan. Since we’re focusing on what a 2-1 buydown is in this article, let’s explore it a little deeper.
The 2-1 Buydown
As we mentioned above, this type of buydown is a temporary financing technique with tiered pricing that reduces interest rates for the first two years of the loan term. As one of the most common types of buydown structures, it’s important to know how the process works.
Going Through The Process
So, how does a 2-1 buydown work? The discounted interest rate doesn’t magically appear out of thin air. Rather, the borrower receives the lower rate in one of two ways.
One option is where the buyer pays a lump sum that goes into an escrow account with the lender. That amount of money compensates for the lower monthly payments the borrower will make during the first two years of the loan term. A second option is where the borrower pays a certain amount of discount points to buy down the interest rate. Once the agreed-upon number of points has been paid, and a buydown settlement has been reached, the monthly payments are reduced for the first two years of the loan term.
Whichever option you choose, your interest rate will get knocked down on your monthly mortgage payments for the first two years. But how is the new, reduced interest rate determined?
Example Of A 2-1 Buydown
You don’t need a fancy 2-1 buydown calculator to figure out what your interest rate will be with this type of financing. So, if you hated math in high school, don’t worry– determining your new interest rate is a lot easier than doing trigonometry proofs.
The tiered pricing of this temporary type of buydown works like this: You get an interest rate that’s 2% lower than what the standard rate would be for the first year of the loan term. Then, you get an interest rate that’s 1% lower than what the standard rate would be for the second year. Finally, you get the standard interest rate for the third year until the loan reaches its term.
So, let’s say that you take out a $300,000 15-year loan that has a standard interest rate of 6%. For the first year, you’ll only be expected to pay an interest rate of 4% since 6% - 2% = 4%. For the second year, you’ll only be expected to pay an interest rate of 5% since 6% - 1% = 5%. Then, from years three through fifteen, you’ll pay the standard rate of 6%.
Reaping The Benefits
Scoring a lower interest rate buydown financing option can be beneficial for both the buyer (who’s also the borrower) and the seller. So, let’s go over how it can be a good move for both parties.
For The Buyer
This type of buydown offers a safe way for borrowers to leverage a lower interest rate and thus, make lower monthly payments for the first couple of years of their loan term. Not only does this make the mortgage more affordable in the beginning, but it’s also a clever way to shield oneself against potential hikes in interest rates.
Likewise, having lower payments in the initial years frees up cash for other important purchases, like home renovations or landscaping.
For The Seller
A seller buydown loan can also benefit someone who’s trying to sell a home that’s been on the market for a long time. Opting for a 2-1 seller-paid buydown– where the seller buys down the interest rate on a buyer’s mortgage– can give sellers a leg up in the housing market. It gives potential buyers who’ve been on the fence about buying a house an incentive to make an offer.
Plus, as the seller, you won’t feel as much pressure to lower your listing price. This is because you’ll already be doing the buyer a favor by lowering their monthly mortgage payments.
Before You Jump In
Like every other type of loan on the market, this type of temporary buydown mortgage doesn’t come without its limitations. It’s important to remember that by the third year of the loan, you’ll have to make increased monthly payments. So, before putting pen to paper, make sure that you’re confident you’ll be able to afford the monthly payments when they rise.
You’ll also be responsible for higher upfront costs (unless the seller pays the fees). But, if you’ll be the one buying down the mortgage, make sure you’ve saved up enough money. Or, at least be certain you’ll make more income in the next couple of years to make up for the higher costs you paid at closing.
Is A 2-1 Buydown Right For Me?
Once you’ve looked at what the 2-1 buydown pros and cons would be for your situation, you can figure out whether this type of financing would be a smart move for you. But, in a nutshell, as long as you have enough savings or an expected increase in your income, buying down a mortgage can be a great way for you to save some money in the long run.
Questions About 2-1 Buydowns? We’ve Got You Covered.
Now that you understand what a buydown mortgage is, you won’t sweat it when you find your dream home and need a mortgage with a lower interest rate to purchase it. But you might still have questions about how a buydown applies to your financial scenario.