When comparing different mortgages, one of the most important variables you will need to consider is the interest rate. Over a 30-year mortgage, a single percentage point change in your interest rate could cost or save you thousands of dollars.
Many people assume that whatever interest rate their lender offers them is an interest rate they simply have to accept. However, there are quite a few situations in which you can readjust your interest rate – especially in the earlier years of your mortgage loan.
One way to modify your mortgage interest rate is through the use of a mortgage rate buydown. Essentially, by paying a lump sum of money upfront, a mortgage buydown will allow you to pay a lower interest rate for a predetermined amount of time.
There are quite a few situations where using a mortgage buydown could make good financial sense. There are also situations where using a buydown mortgage will end up costing you money. In this guide, we will discuss how buying down your mortgage rate works, its benefits, its drawbacks and whether buying down your interest rate makes sense for you.
Buying Down Interest Rates, Explained
Buying down your mortgage rate will allow you to secure a lower interest rate (meaning lower monthly payments) for either the entire length of the mortgage or a predetermined amount of time. This process is often referred to as a mortgage buydown.
When you apply for a mortgage, your lender will let you know the interest rate you will be expected to pay. This rate is determined by several factors, including the current state of the mortgage market and your credit score.
However, they might be willing to offer a lower interest rate if you are willing to make an initial lump sum payment. In other words, you might be able to buy a lower interest rate.
How does a buydown mortgage work?
A buydown mortgage works by allowing you to buy points (sometimes referred to as discount or mortgage points) upfront in exchange for a lower interest rate.
The cost of a mortgage point is based on the size of your mortgage loan, with one point representing 1% of your mortgage. For a $200,000 mortgage, one point would equal $2,000, two points would equal $4,000 and half a point would equal $1,000.
When a lender offers a buydown mortgage to its borrowers, they typically phrase the offer as “decreasing your interest rate by X amount will cost Y discount points.”
By buying points upfront, you get a lower interest rate. This can lower the amount you pay over the life of your mortgage and potentially save you money over your loan term.
The way a buydown mortgage works depends on the lender you are working with, as well as your current financial situation. Not all mortgage lenders will offer a buydown option to all of their clients, but buydown mortgages are still fairly common.
What types of buydown mortgages are there?
There are two different types of mortgage buydowns.
- Permanent mortgage rate buydown: For a permanent mortgage rate buydown, the borrower will pay for discount points at closing, which lowers their rate for the entire length of their mortgage. By paying for more discount points, the borrower can lower their rate even further, though there may be a limit on how many discount points they can buy.
With these types of buydowns, as long as the borrower is applying for a fixed-rate mortgage (instead of an adjustable-rate mortgage), the new rate and corresponding monthly payment will always remain the same.
- Temporary mortgage rate buydown: A temporary mortgage rate buydown, on the other hand, allows the buyer to lower their interest rate at the beginning of the mortgage but, eventually, their rates will return to “normal.” When compared to a permanent mortgage rate buydown, lowering your interest rate temporarily is more affordable, though you don’t save as much over time.
How much does a buydown mortgage cost?
The exact cost of a mortgage buydown will depend on several factors, including the size of the mortgage, the amount you are buying down the loan by and the various fees associated with the buydown.
Ultimately, the cost of a buydown will be set by the lender, though there may be room for negotiation.
Who can get a buydown?
Both buyers and sellers can initiate a mortgage buydown. But not everyone who can qualify for a mortgage will necessarily qualify for the buydown. Policies vary by lender, but you typically need to make a down payment of at least 20% and have a good credit score.
Are there limits to mortgage buydowns?
Technically, there are no limits to the number of mortgage points you can buy down. However, the lender and the type of mortgage you have may put limits on your ability to buy points. If you have the cash to spare, you may benefit more from applying the money toward your down payment or simply setting the money aside for emergencies.
Types of Buydown Structures
There are several different types of buydown structures. Some of the most common include 3-2-1 buydowns, 2-1 buydowns and evenly distributed interest rate reductions.
With a 3-2-1 buydown, borrowers will have their lowest payment in the first year, followed by two years of increasing payments until they reach their permanent rate for years 4 – 30.
Suppose you are applying for a 30-year mortgage for $300,000, and the current interest rate is 6%. Below is how your payments would be structured.
|Year||Interest Rate||Monthly Payment|
|4 – 30||6%||$1,799|
In this situation, you would save $13,061 over the first 3 years. Assuming the lender offered you this buydown for 3 points ($9,000), you would save $4,061 by taking the buydown, but those savings would be distributed over the first 3 years of your mortgage.
A 2-1 buydown would have the same payment structure as 3-2-1 buydown. But instead, year one would be removed, and the permanent payment would stabilize in year three. A 2-1 buydown will typically cost fewer points than a 3-2-1 buydown, but the savings will also be less.
Evenly distributed interest rate reductions
An evenly distributed interest rate reduction is the same as a permanent mortgage rate buydown. Essentially, this means paying more upfront to have a lower rate applied to the entire length of the mortgage. With a permanent interest rate reduction, the longer you live in your home, the more you will end up saving.
Alternatives to a Buydown Mortgage
If you’re looking for a way to lower your mortgage interest, but don’t have the cash for a buydown mortgage, there are other options available.
If interest rates are high and you want to pay less in interest at the beginning of your loan, a mortgage buydown isn’t your only option.
You may want to consider an adjustable-rate mortgage (ARM). With an ARM, you get a lower introductory interest rate for the first 3 – 10 years. After that, your interest rate adjusts up or down based on the terms of your loan and current market interest rates.
The key benefit of an ARM is that you can save money with a lower interest rate and don’t have to pay money upfront for mortgage points. The key risk is that interest rates could go up later, which can raise your monthly mortgage payments after your introductory period ends.
On the other hand, if interest rates are currently high, you could luck out and emerge from your introductory period with a lower interest rate. If your introductory rate is ending and interest rates are still high, you may want to consider refinancing to lock in your interest rate.
If you’re looking for ways to get a lower interest rate on your mortgage, you might find it helpful to consider a loan program backed by the U.S. government.
While many of these loans make it possible to borrow with as little as 0% down, the ability to make a larger down payment could help you get a better interest rate, especially if you have a lower credit score or haven’t been able to build a credit history.
- Federal Housing Administration (FHA) loans: FHA loans are available for borrowers with credit scores as low as 500 with a 10% down payment. If you have cash in hand but poor credit, you may qualify for a better interest rate with an FHA loan. Although, you will need to pay mortgage insurance premiums, both upfront and every month you own your home.
- Department of Veterans Affairs (VA) loans: VA loans are available to veterans of the U.S. Armed Forces and their surviving spouses. VA loans offer low interest rates with no credit score or down payment requirements. While there are no government requirements for credit scores and down payments, each lender will have varying criteria you need to meet, so be sure to ask what your lender’s qualifications are.
- U.S. Department of Agriculture (USDA) loans: If you’re looking to buy or build a home in a designated rural area, USDA loans offer competitive interest rates with minimal down payment requirements.
Calculating if a Buydown Mortgage Is Worth It
For a mortgage buydown to be “worth it,” you will want to make sure you end up saving more than the total cost of a buydown. Let’s say you have a 3-2-1 buydown that has an original cost of $10,000 and provides $15,000 in total savings over the first 3 years.
To calculate your breakeven point, simply divide the savings achieved in 3 years ($15,000) by the original cost ($10,000), which gives you a breakeven point of 1.5. This means to make the buydown worth it, you must live in your home for at least 1.5 years (18 months).
What You Should Consider Before Buying Down Interest Rates
While a mortgage buydown may seem like a no-brainer, you’ll want to consider the pros and cons of buying down your interest rate.
The main reason to get a mortgage buydown is to save money. If you plan to live in your home past your breakeven point, a buydown will be easy to financially justify. Additionally, if you’re able to buy down some of your points, you may qualify for a larger home loan.
Or if you’re starting your career, but anticipate making more money later, you may benefit from having a lower monthly payment on your mortgage loan.
Also, if you meet the qualifications set by the IRS, you can deduct the cost of your buydown on your tax return, either in full the year you buy them or over the life of the loan.
Of course, there are some drawbacks to a mortgage buydown. Most notably, you’ll need to pay more at the time of closing, which might make it unaffordable. Many people have a lot of immediate expenses when they move into a new home, so make sure you have the money available. Otherwise, you run the risk of not having savings available in case of an emergency.
Is a Buydown Right for Me?
If you have the money available and plan on living in your home past the break-even point, a mortgage buydown can be very beneficial. Just be sure to explore your options and lean on the side of caution.