How Much Does a Rate Buydown Actually Cost?

A mortgage rate buydown reduces the interest rate on a home loan, either temporarily or for the entire loan term. This strategy aims to lower monthly mortgage payments, making homeownership more accessible. Understanding the cost involves examining how these reductions are structured and their upfront fees. This article explains the components determining a rate buydown’s expense.

Understanding Buydown Points

Buydown costs involve “points.” A mortgage point is a fee paid to the lender for a lower interest rate. Typically, one point equates to one percent of the total loan amount. For instance, on a $300,000 mortgage, one point costs $3,000.

These points are prepaid interest, paid at closing. Purchasing discount points reduces the interest rate, typically by about 0.125% to 0.25% per point. Lenders allow the purchase of fractions of a point or up to several points to achieve the desired rate reduction.

Buydowns are structured as either temporary or permanent. A permanent buydown lowers the interest rate for the entire loan duration. A temporary buydown, such as a 2-1 or 3-2-1 structure, reduces the interest rate for an initial period before it increases to the original note rate. The upfront cost for a temporary buydown equals the interest the borrower saves during the discounted period.

Calculating Buydown Costs

Calculating the cost of a rate buydown depends on whether it is a temporary or permanent arrangement. For a permanent buydown, the cost is a direct function of the loan amount and points purchased. For example, if a borrower secures a $400,000 mortgage and wishes to reduce their interest rate by 0.50%, requiring two points, the upfront cost would be $8,000 (2 points x 1% of $400,000).

Temporary buydowns involve a more intricate calculation, as the cost represents the sum of interest savings over the reduced rate period. Consider a 2-1 buydown on a $300,000, 30-year fixed-rate mortgage with an original interest rate of 7.0%. In the first year, the rate would be 5.0% (7.0% – 2.0%), and in the second year, it would be 6.0% (7.0% – 1.0%). After the second year, the rate reverts to 7.0% for the remaining loan term.

To calculate the cost of this 2-1 buydown, determine the monthly principal and interest payments for each year of the buydown period and compare them to payments at the original 7.0% rate. For example, a $300,000 loan at 7.0% has a monthly principal and interest payment of $1,996. At 5.0% for the first year, the payment is $1,610, and at 6.0% for the second year, it is $1,799. The annual savings are the difference between the full payment and the buydown payment for each year.

The total cost of the buydown is the aggregate of these annual savings, deposited into an escrow account at closing. The lender draws from this account monthly to cover the difference between the borrower’s discounted payment and the actual payment due at the original rate. For instance, first-year savings are $1,996 – $1,610 = $386 per month, totaling $4,632 annually. Second-year savings are $1,996 – $1,799 = $197 per month, totaling $2,364 annually. The combined cost of this 2-1 buydown is $4,632 + $2,364 = $6,996. This method illustrates how the buydown cost is directly tied to the interest saved.

Factors Influencing Buydown Expense

Several elements influence a rate buydown’s total expense. Prevailing market interest rates influence cost; in a high-rate environment, the difference between the original and desired lower rate can be substantial, increasing the buydown cost. When rates are already low, there is less room for significant rate reduction, impacting the cost. Individual lender policies also affect buydown expenses, as they determine how many points are required for a certain rate reduction.

The desired amount of rate reduction directly impacts the cost. A larger interest rate reduction, whether temporary or permanent, necessitates a higher upfront payment in points or escrowed funds. The total loan amount is a direct multiplier for calculating point costs, since each point is one percent of the loan. A larger loan incurs a higher cost for the same number of points. For temporary buydowns, the duration of the buydown period also affects the expense, as a longer period of reduced payments means a greater sum of interest savings must be covered upfront.

Payment Responsibilities for Buydowns

The responsibility for paying for a rate buydown can fall to several parties, typically determined during real estate transaction negotiations. While a borrower can choose to pay, sellers or builders commonly offer buydowns as an incentive to attract buyers, particularly in competitive or slower markets. These parties contribute funds to cover the buydown cost as part of a concession.

When a seller or builder pays for a temporary buydown, funds are deposited into an escrow account at closing. The mortgage servicer draws from this account monthly to supplement the borrower’s reduced payment, ensuring the full interest amount is paid to the lender. This arrangement allows the buyer to benefit from lower monthly payments without an additional upfront cash outlay. For permanent buydowns involving discount points, the cost is included as part of the closing costs. Regardless of who pays, the payment is a one-time upfront fee made at loan closing.