How Much Does a 3-2-1 Buydown Cost?
Understand the true cost of a 3-2-1 buydown mortgage. Learn how its financial impact is determined and who typically pays for this temporary interest rate strategy.
A 3-2-1 buydown is a mortgage financing strategy designed to temporarily reduce a borrower’s interest rate during the initial years of a loan. This article explains the financial outlay of a 3-2-1 buydown, its structure, and cost determinants.
How a 3-2-1 Buydown Works
A 3-2-1 buydown operates by offering a graduated interest rate reduction for the first three years of a mortgage. The interest rate is typically reduced by 3 percentage points below the permanent note rate in the first year. This reduction then lessens to 2 percentage points in the second year and 1 percentage point in the third year. After the conclusion of the third year, the interest rate reverts to the original, permanent rate for the remainder of the loan term.
Components of Buydown Cost
The cost of a 3-2-1 buydown represents the total amount of interest savings a borrower receives over the three-year period. This cost is not an additional fee added to the loan but rather a sum of money paid upfront to cover the difference between the reduced monthly payments and what the payments would have been at the full, permanent interest rate. The permanent interest rate of the mortgage, the principal loan amount, and the specific 3-2-1 percentage reductions are all primary determinants. The larger the loan amount or the higher the permanent interest rate, the greater the potential monthly savings will be, directly increasing the total buydown cost.
Calculating the Total Buydown Cost
Calculating the total cost of a 3-2-1 buydown involves determining the difference in monthly principal and interest payments for each of the three years and then summing those differences. This upfront payment is typically placed into an escrow account and drawn upon monthly by the lender to cover the payment differential.
Consider a scenario where a borrower secures a $350,000, 30-year fixed-rate mortgage with a permanent interest rate of 7.00%. The standard monthly principal and interest payment at this permanent rate would be approximately $2,328.69.
With a 3-2-1 buydown, the effective rate for the first year would be 4.00%, resulting in a monthly payment of about $1,670.92. This creates a monthly savings of $657.77, totaling $7,893.24 for the first year.
In the second year, the effective interest rate would be 5.00%, leading to a monthly payment of approximately $1,878.50. This generates a monthly savings of $450.19, accumulating to $5,402.28 over the second year. For the third year, the effective rate becomes 6.00%, with a monthly payment of around $2,098.43. This provides a monthly savings of $230.26, amounting to $2,763.12 for the third year. Summing these annual savings reveals a total buydown cost of $16,058.64 for this example.
Another illustration involves a $450,000, 30-year fixed-rate mortgage at a permanent interest rate of 6.50%. The monthly principal and interest payment at this permanent rate would be approximately $2,844.75.
Under a 3-2-1 buydown, the first year’s effective rate would be 3.50%, leading to a monthly payment of about $2,020.32. This results in a monthly savings of $824.43, or $9,893.16 for the year.
The second year’s effective rate would be 4.50%, with a monthly payment of approximately $2,280.08. This yields a monthly savings of $564.67, totaling $6,776.04 for the second year. In the third year, the effective rate adjusts to 5.50%, with a monthly payment of around $2,554.43. This provides a monthly savings of $290.32, which totals $3,483.84 for the third year. The cumulative buydown cost for this scenario would be $20,153.04.
Parties Responsible for the Buydown Cost
The cost of a 3-2-1 buydown is typically covered by a party other than the homebuyer. Most commonly, the home seller or the home builder funds the buydown. Sellers might offer this to make their property more appealing in a competitive market or to facilitate a quicker sale. Home builders often utilize buydowns to stimulate sales, particularly for new construction inventory, by making homes more affordable for prospective buyers.
In some instances, the mortgage lender might contribute to the buydown cost. While less common for a full 3-2-1 structure, a buyer could theoretically contribute to or fully fund a buydown. Regardless of the funding source, the entire buydown amount is usually deposited into an escrow account at closing. From this account, the lender withdraws funds each month to supplement the borrower’s reduced payment, ensuring the full contractual payment is made to the loan servicer.
Federal Housing Administration (FHA) loans allow up to 6% of the sales price in seller concessions, which can include buydown costs. Similarly, Veterans Affairs (VA) loans permit seller concessions up to 4% of the loan amount, within which buydown costs must fit.