What is a Buydown?

What is a Buydown

One of the tricky things about preparing to become a new homeowner is that it can feel as though you are suddenly supposed to be conversant with an entirely new jargon. You might have encountered the term "buydown" and wondered what it was and if it could be advantageous to you in some way. The answer is really "maybe," so it's good to be familiar with what exactly this term means and what its advantages and disadvantages are.

The Basics

A buydown is a method that allows you to take a lower interest rate for the first few years that you have a mortgage. The terms are generally for two years, known as a 2-1 buydown, or for 3 years, known as a 3-2-1 buydown.

There are types of loans in which a buydown is not an option, and others, such as FHA loans, where guidelines specify their use. There are additional restrictions as well based on other factors, such as what state you live in.

A lower interest rate sounds like an unequivocal good, so you might think that there would be no reason to turn down a buydown. However, there is a lot more to it than just getting lower interest rates for two or three years.

Mortgage Points

You don't get a buydown just by asking for one. You might have to pay a price for your buydown. Buydowns are obtained via what are called mortgage points or discount points at the time that you close on the house.

These points may be funded by the buyer, the seller or the builder of the home although it is usually the buyer. If you are the buyer and you are paying, you would negotiate with the lender. Essentially, paying a fee upfront to the lender will lead to a reduction in the interest rate that you pay for the agreed-upon length of time. Of course, you will need to determine whether that amount that you pay up front will result in savings when it comes to the lowered payments that you make over the next two or three years.

Points are calculated based on a percentage of the mortgage, and in turn, the lender agrees to take a certain percentage off the interest rate.

You might wonder why a seller would agree to pay for these points. There are a couple of reasons. Remember that just as much as you want to get a house you like at a good price, the seller wants a sale. From their point of view, the buydown might sweeten the deal enough to persuade you to close. Points can give buyers a tax advantage, so it might be more tempting to buy a house that includes a buydown offer than if the seller took the same amount off the asking price.

The seller may deposit money in an escrow account. That money is then used toward the buyer's payments.

In new developments, builders may offer these points to draw more interest in their properties. These are less likely to be offered in established developments.

Your real estate agent may be able to negotiate with the seller or builder on your behalf and get them to cover the costs of a buydown.

Advantages and Disadvantages of Buydowns

It's important to really break down the numbers and determine whether it's to your advantage to take this reduction on your interest rate for two or three years, and there are a number of online calculators, charts and other tools that can help you do this.

However, there are also a few things that you should think about when you're deciding if this is the right choice for you.

First of all, how long do you plan to stay in your home? If you're only going to be there for five years or less, a buydown may not pay off.

Do you have a reliable salary that you expect to increase in the years ahead? A buydown can be a great opportunity for someone who is early in their career who could benefit from a few years of lower payments with the expectation of a predictable rise in income. On the other hand, if you have a lower income two or three years after buying the house, that increase in payments could be especially painful. No one can predict the future, but this might be a more risky venture for someone who is a freelancer or self-employed than someone who is on a well-trodden career path upwards.

If you're the one who has to pay for the buydown, do you have the money up front to do so? Closing costs and other expenses associated with owning a house can eat up a lot of cash. This may not be the most prudent use of any extra money that you do have.

Make sure as well that you're happy with the price of the house if the seller is offering the buydown. Some sellers might increase the price in order to make up for what they are spending on the buydown.

Be aware as well that if funds are in escrow and for some reason those funds become unaccessible, you will be responsible for paying the difference.

With these precautions in mind, a buydown can lead to real savings in the right circumstances.

Types of Buydowns

There are a few different options for buydowns.

For example, if you don't want to pay as much up front but would still like a reduction in the interest rate for a time, you might opt for a 1-0 buydown, which allows you to pay 1% less in interest for one year. In a 1-1-1 buydown, you'll be able to do that for the first three years.

You might opt for a 2-1 buydown, which would allow you to pay 2% less in interest for the first year and 1% less in interest for the second year. A similar option is a 3-2-1 buydown, which you might be able to guess allows you to pay 3% less in year one, 2% less in year two and 1% less in year three. Both of these can be great ways to ease into the full payments, but the latter can mean that you need to make a substantial payment up front at the same time that you're dealing with all the other costs associated with buying a house and new home ownership.

Keep in mind that you have to agree on a buydown before you close on the house. After that point, it's no longer an option.

A buydown is one of many ways to potentially save on the cost of your home over a period of years. If you have the opportunity to use a buydown, it's important to get as much information as possible so that you can make the most financially advantageous choice for your particular situation.

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