How Much Does a 2-1 Buydown Cost?
Demystify 2-1 mortgage buydowns. Gain clarity on their true financial outlay, what impacts it, and how this temporary rate strategy is managed.
Demystify 2-1 mortgage buydowns. Gain clarity on their true financial outlay, what impacts it, and how this temporary rate strategy is managed.
A 2-1 buydown is a mortgage financing strategy designed to temporarily reduce a borrower’s initial interest rate and, consequently, their monthly mortgage payments during the early years of a loan. This approach offers a period of lower payments before the interest rate adjusts to its permanent level, providing financial relief during the initial phase of homeownership. The structure of a 2-1 buydown specifically targets the first two years of the mortgage term.
A 2-1 buydown applies a temporary reduction to the mortgage interest rate for the first two years. In the first year, the interest rate is typically reduced by 2 percentage points below the original, permanent note rate. For instance, if the permanent rate is 7%, the effective rate for the first year would be 5%. This significantly lowers the monthly payment, providing a more affordable start.
During the second year, the interest rate increases, but remains below the permanent note rate. The reduction for the second year is generally 1 percentage point below the original note rate. Continuing the example, a 7% permanent rate would translate to an effective rate of 6% in the second year. This structured increase allows for a gradual adjustment in monthly payments.
After the second year, the temporary buydown period ends. The interest rate reverts to the original, permanent note rate that was established at the loan’s inception. For the remainder of the loan term, the borrower will make payments based on this full, fixed interest rate.
The total cost of a 2-1 buydown is the sum of the difference between the actual monthly payment at the permanent interest rate and the reduced monthly payment for each of the 24 months. This cost covers the interest rate subsidy provided in the first year (2% reduction) and the second year (1% reduction).
Consider a 30-year fixed-rate mortgage with a principal loan amount of $400,000 and a permanent note interest rate of 7.0%. The standard monthly principal and interest payment for this loan would be approximately $2,661.21.
For the first year, the interest rate is reduced to 5.0%. The monthly principal and interest payment on a $400,000 loan over 30 years would be approximately $2,147.29. The monthly savings for the borrower would be $2,661.21 – $2,147.29 = $513.92. Over 12 months, the total savings for the first year amount to $513.92 12 = $6,167.04.
In the second year, the interest rate is reduced to 6.0%. The monthly principal and interest payment for a $400,000 loan at 6.0% over 30 years would be approximately $2,398.28. The monthly savings in the second year are $2,661.21 – $2,398.28 = $262.93. For the second year, these savings total $262.93 12 = $3,155.16.
Adding the savings from both years provides the total cost of the 2-1 buydown. In this example, the total cost would be $6,167.04 (Year 1 savings) + $3,155.16 (Year 2 savings) = $9,322.20.
The loan amount is a significant factor influencing the overall cost of a 2-1 buydown. A larger principal balance means a given percentage point reduction in interest translates to a greater dollar amount of savings each month. Consequently, a higher loan amount will result in a proportionally higher total buydown cost. For instance, a $500,000 loan will require a larger upfront payment for the same buydown structure than a $300,000 loan.
The original, or note, interest rate of the mortgage also plays a considerable role. When the permanent interest rate is higher, the difference between that rate and the temporarily reduced rates (2% and 1% below) is larger in dollar terms. This wider gap means the monthly subsidy required is greater, leading to a higher total buydown cost. Conversely, a lower permanent interest rate would necessitate a smaller buydown amount.
Prevailing market interest rates can influence the desirability and prevalence of 2-1 buydowns. In periods of high market interest rates, a 2-1 buydown becomes more attractive as it offers immediate relief from elevated monthly payments. This market context can encourage sellers or builders to offer buydowns more frequently as an incentive, indirectly affecting the demand and perceived value of such arrangements.
The cost of a 2-1 buydown is typically covered by a third party, most commonly the seller of the property or the home builder, as a sales incentive. In some instances, lenders may also contribute to the buydown as part of their loan offerings. While less frequent, a buyer may also elect to pay for the buydown themselves.
The total buydown amount is usually placed into an escrow or custodial account at the time of the loan closing. This upfront lump sum is held by the lender or a designated third party. The funds in this account are specifically earmarked to cover the difference between the borrower’s reduced monthly payment and the full payment due to the lender.
Each month during the two-year buydown period, the lender draws the necessary amount from this escrow account to supplement the borrower’s lower payment. The borrower simply makes their lower, scheduled payment, and the escrow account covers the remainder.
Should the loan be refinanced or paid off entirely before the two-year buydown period concludes, any remaining funds in the escrow account are typically disbursed. These unused funds are usually returned to the party who initially funded the buydown, such as the seller or builder. If the buyer paid for the buydown, the remaining funds would generally be applied to the loan balance or returned to them.