How Much Does a 3-2-1 Buydown Cost?

A mortgage buydown is a financing technique designed to make homeownership more accessible by temporarily reducing the interest rate on a home loan. This approach allows borrowers to benefit from lower monthly payments during the initial period of their mortgage. Among various types, the 3-2-1 buydown stands out as a specific structure that provides a stepped reduction in the interest rate.

Mechanics of a 3-2-1 Buydown

The “3-2-1” aspect of this buydown refers to the percentage points by which the mortgage interest rate is reduced over the first three years of the loan. In the first year, the interest rate is 3% lower than the permanent, agreed-upon rate. As the buydown period progresses, the rate gradually increases. During the second year, the interest rate is 2% lower than the permanent rate, followed by a 1% reduction in the third year. After the third year, the interest rate reverts to the permanent rate for the remainder of the loan term.

This temporary reduction is facilitated through an escrow account, which is funded upfront at the loan closing. This account holds the funds necessary to subsidize the difference between the reduced buydown rate and the permanent interest rate during the initial three years. Each month, a portion of these funds is released from the escrow account to cover the interest subsidy, effectively lowering the borrower’s payment.

Determining the Buydown Cost

The “cost” of a 3-2-1 buydown represents the lump sum amount deposited into an escrow account to cover the interest rate subsidy. The calculation of this cost involves summing the differences in interest payments for each of the three buydown years. It is determined by comparing the monthly principal and interest payment at the permanent rate against the reduced payments at the buydown rates, multiplied by the loan balance for those respective periods.

For example, if a loan has a $400,000 balance and a permanent interest rate of 7%, the buydown would reduce the rate to 4% in year one, 5% in year two, and 6% in year three. Key factors influencing this cost include the original loan amount, the permanent interest rate, and the specific buydown structure. A larger loan amount or a greater difference between the permanent rate and the buydown rates will result in a higher upfront cost.

This upfront cost is typically paid by a third party, such as the home seller or a home builder, as an incentive to attract buyers or facilitate a sale. While less common, a borrower can also negotiate to pay this cost themselves, though this is often not financially advantageous compared to other options like paying discount points for a permanent rate reduction. The funds placed in escrow are solely for the benefit of the borrower, ensuring the temporary rate reductions are honored.

Borrower’s Payment Structure

The 3-2-1 buydown directly impacts the borrower’s monthly mortgage payments by significantly reducing them during the initial three years. This temporary financial relief can be particularly beneficial for new homeowners who may face other expenses related to moving and settling into a new property. The monthly payment is calculated based on the temporarily reduced interest rate for each of the three years.

For instance, consider a $350,000 loan with a permanent interest rate of 7.5%. With a 3-2-1 buydown, the borrower’s payment in the first year would be based on a 4.5% rate (7.5% – 3%), then 5.5% in the second year (7.5% – 2%), and 6.5% in the third year (7.5% – 1%). From the fourth year onward, the monthly payment adjusts to reflect the full 7.5% permanent interest rate for the remainder of the loan term.

Borrowers benefit from these reduced payments without directly funding the upfront buydown cost, assuming a third party covers it. The escrow account effectively subsidizes their payments, making homeownership more affordable in the short term. It is important for borrowers to understand that while their monthly out-of-pocket payment is lower, the underlying loan balance and the permanent interest rate remain unchanged.