Over the past two-years the rapid increase in mortgage rates shocked potential homebuyers. The average 30-Year Mortgage Rate increased from 3.22% in January 2022 to a 40-Year high of 7.08% by the end of October 2022. The spike in mortgage rates basically doubled the cost of homeownership. When mortgage rates are high, borrowers will look for ways to lower their monthly payment. One of the options available to help you reduce your mortgage rate and monthly mortgage payment is a buydown. A buydown may be the perfect way to make your monthly mortgage payment more
What is a Buydown?
Buying down the mortgage rate means paying an extra fee upfront to get a lower rate and lower monthly payment. There are two buydown programs. A Permanent Buydown and a Temporary Buydown. Each buydown program has different parameters, benefits and disadvantages. When choosing a buydown program, it is important to understand the costs, benefits and disadvantages of each:
Permanent Buydown: The Permanent Buydown Program results in a lower mortgage rate for the life of the loan. The buyer pays an upfront fee to lower the mortgage rate reducing the monthly mortgage payment. How much can a Permanent Buydown lower the mortgage interest rate? The most commonly used Permanent Buydown formula is a 4-1 Buydown. This means each discount point paid reduces the mortgage rate by .25%. If the borrower paid 4 upfront discount points, the mortgage rate would be reduced by 1% for the life of the loan. The 4-1 is the most used formula. If we used a $500,000.00 example, and you desired to use a Permanent Buydown to lower a 7% mortgage rate to 6% for the term of loan the upfront Discount Points would be 4% totaling $20,000.00. Your mortgage payment would be reduced from $3,327.00 to $2,998.00 saving $329.00 per month.
Temporary Buydown: The Temporary Buydown allows the borrower to reduce the payment rate for a defined period of time. This can be a very effective way to significantly reduce your mortgage payment. There are several ways to temporarily buydown your payment. You will hear 3-2-1 Buydown, 2-1 Buydown, 1-1 Buydown. Sounds confusing? The list of numbers just explain the buydown of the payment rate per year. For example the 3-2-1 means: For the first year your mortgage payment is based on a payment rate 3% below the note rate. For the second year your mortgage payment is based on a payment rate 2% below the note rate. For the third year your mortgage payment is based on a payment rate 1% below the note rate. For the fourth year your mortgage payment is based on the actual note rate ….. 3-2-1! One of the misconceptions is the mortgage interest rate is reduced. That is not how a Temporary Buydown works. The Temporary Buydown allows the borrower to pay the difference between the actual note rate and the buydown payment rate at closing to lower the monthly mortgage payment. How does a Temporary Buydown work? If your actual note rate is 7%, and you used a 3-2-1 Temporary Buydown, the first year mortgage payment is based on a payment rate of 4%. The second year mortgage payment is based on a payment rate of 5%. The third year mortgage payment is based on a payment rate of 6%.
How much does this help? Let’s look at an example of a 2-1 Temporary Buydown with a $500,000.00 loan amount, and a 7% 30-Year Fixed Rate Mortgage. A 30-Year Fixed Rate Mortgage at 7% would have a P+I payment of $3,327.00. The first year payment rate of a 2-1 Temporary Buydown would be 5% resulting in a monthly P+I payment of $2,685.00 saving $642.00 per month. The second year payment rate would be 6% resulting in a monthly P+I payment of $2,998.00 saving $329.00 per month. The total savings over the first two -years of your loan are $11,652.00.
The hidden benefit of a Temporary Buydown. When you chose Temporary Buydown the points paid upfront are placed in an interest escrow account. Each month the difference between the monthly payment based on the note rate and the monthly payment based on the “payment rate” is deducted from the escrow account, and applied to the actual note rate payment. Remember, the Temporary Buydown does not reduce the actual note rate. Keeping the $500,000.00 example. The note rate payment due is $3,327.00 and the first year Temporary Buydown payment rate payment is $2,685.00. The difference of $642.00 is deducted from the interest escrow and applied to the note rate payment due. If you sell the home or refinance your mortgage, the remaining balance of the interest escrow account is applied Principal balance of your loan.
What is the Payment Rate?
You may notice we keep referencing the “payment rate.” When you choose a Permanent Buydown, you actually buydown the note rate on your mortgage for the entire term of the loan. When you choose a Temporary Buydown the note rate on the mortgage remains the same for the entire term of the loan. You pay upfront interest, reflected in points, to reduce the “payment rate” during a fixed period of time. The note rate remains the same, but your mortgage payment is based on the lower “payment rate” for a year significantly reducing your mortgage payment.
What are Discount Points?
Discount Points and Origination Fees are different. Origination Fees, which may be charged as points, are paid to the mortgage lender for processing, underwriting and closing a loan. Discount Points are interest paid at closing to reduce the mortgage rate paid over the life of a loan. What is a point? A point equals 1% percent of your loan amount. For example one point of a $100,000.00 loan amount = $1,000.00 ($100,000.00 x 1% = $1,000.00). If you are borrowing $500,000.00 and paid two Discount Points the upfront cost of the Buydown is $10,000.00. ($500,000.00 x 2% = $5,000,00).
Do I have to pay the Discount Points For the Buydown?
The cost of a buydown may be borrower paid as part of your closing costs. However, other parties involved in a Real Estate transaction may help pay the upfront cost of the buydown. The seller may pay the cost of the buydown as part of the seller paid closing costs. Your lender may offer a “Lender Credit” that can be used to pay the upfront cost of a buydown.
That’s a lot of information. What is the best option?
The buydown is an effective tool to lower your monthly mortgage payment. To determine the best strategy we need to know: What is the cost of the buydown? How long do you plan to keep the mortgage or stay in the property? What is the monthly savings? How long does it take to recover your investment? Let’s take a look at both the Permanent Buydown and Temporary Buydown using our $500,000.00 example
The bottom line is the use of a Buydown program can be a very effective way to reduce your monthly mortgage payment. If you would like to learn more about how a Buydown works and if it is right for you, please contact your FDM Mortgage Professional today.