Table of Contents
- Types of Buydowns
a. 3-2-1 Buydown
b. 2-1 Buydown
c. Permanent Buydown
- The Breakeven Point
- Pros and Cons of a Buydown
a. Pros of a Buydown
b. Cons of a Buydown
A buydown is a technique to finance mortgages such that buyers can enjoy a lower interest rate when taking out a mortgage loan for a property they wish to purchase by paying more up-front. Buyers can lower the interest rate for the first few years of the loan via a 2-1 buydown or 3-2-1 buydown, or lower the interest rate for the entirety of the loan. With lower rates, mortgage payments will be lower, hence making it more affordable for buyers.
Buyers, sellers, and builders of the property can help to buy down by contributing funds to the lender to subsidise the loan, lowering the interest rate of the mortgage. Builders or sellers have the option to offer a buydown to increase the chances of selling the property by making it more affordable.
Types of Buydowns
There are a few types of buydowns. Apart from permanent buydowns that cover the entirety of the loan, temporary buydowns such as the 3-2-1 buydown and 2-1 buydown are other possible options. All of them function using the same principles.
In a 3-2-1 buydown, the buyers have the liberty to pay discounted interest rate for the first three (3) years. Hence, for the first year, the buyer pays 3% less interest on their mortgage. For subsequent years, the interest rate incrementally increases by 1% annually, and the full interest rate apply from the fourth year onwards.
For example, a buyer borrows $200,000 for a 30-year mortgage at an interest rate of 5%. With a 3-2-1 buydown, the buyer pays:
- $739.24 with an interest rate of 2% in the first year
- $843.21 with an interest rate of 3% in the second year
- $954.83 with an interest rate of 4% in the third year, and
- $1073.64 with the original interest rate of 5% from years 4 to 30.
The 2-1 buydown operates similarly as a 3-2-1 buydown, but in this case, the discount applies for the first 2 years instead of 3 years, as in the case of 3-2-1 buydown. Thus for the first year, buyers pay 2% less interest on their mortgage. For the second year, the interest rate increases by 1%, and buyers would pay the full interest rate from the third year onwards.
Using the same example as above, the buyer pays:
- $843.21 with an interest rate of 3% in the first year
- $954.83 with an interest rate of 4% in the second year, and
- $1073.64 with the original interest rate of 5% from years 3 to 30.
Unlike the 3-2-1 buydown and 2-1 buydown, both of which only lowers the interest rate for a fixed period of time, a permanent buydown extends over the entire tenure of the loan. However, this usually involves paying more money up front. This initial amount varies from lender to lender.
The Breakeven Point
In order to determine whether the buydown is worth it, you must first calculate the breakeven point. This is evaluated based on the time it would take to recover the costs incurred to lower the interest rate. To calculate this, you need to divide the cost of the discount points by the monthly savings, where 1 discount point is defined as 1% of the loan amount.
For example, the lender charges you 4 discount points to lower the interest rate by 1%, with a 30-year, $400,000 mortgage with an original interest rate of 5%.
- The cost of lowering the interest rate by 1% would be → 0.04 x $400,000 = $16,000.
- The original monthly mortgage payment at 5% would be → $2147.29
- The new monthly mortgage payment at 4% would be → $1909.66
- Monthly savings → $2147.29 - $1909.66 = $237.63
- Hence, the breakeven point is → 16000/237.63 = 67.33 months
This means it takes approximately 67 months to recover the money that was spent to lower the interest rate. If you intend to own the house for longer than 67 months, a buydown would be beneficial for you.
Pros and Cons of a Buydown
Whether a buydown is an option for you to consider depends on many factors, such as the time period of property ownership, the breakeven point, current and future income, etc.
Pros of a Buydown
- Temporarily lowers interest rates, and subsequently your monthly payments for your mortgage during the early stages of the loan.
- If you expect a higher income in the future, using a temporary buydown will allow you to save on monthly payments now before subsequently easing into higher monthly payments when your income increases over the years.
- If a seller or builder helps to pay the buydown on behalf of buyers without substantially increasing the purchase price of the property, the overall cost incurred would be lower for buyers.
Cons of a Buydown
- Higher costs up-front
- You must have sufficient liquidity to afford the down payment to pay for the buydown.
- Higher than expected monthly payments after the buydown rate ends
- This could potentially result in you defaulting if you are unable to finance the higher monthly payments should your income not increase over the years.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.