What Is a 2-1 Buydown Mortgage and How Does It Work?

A 2/1 buydown mortgage is a financing strategy designed to temporarily reduce a borrower’s mortgage interest rate during the initial phase of their loan. This approach helps make homeownership more accessible and affordable in the short term, especially in environments where interest rates might be higher.

Defining the 2/1 Buydown

A 2/1 buydown offers a reduced interest rate for the first two years of a home loan. The “2/1” refers to the specific reduction in the interest rate: the rate is 2% lower than the permanent rate in the first year and 1% lower in the second year. This is a temporary arrangement, meaning the interest rate will eventually revert to the original, agreed-upon rate for the remainder of the loan term.

A lump sum of money is set aside, typically deposited into an escrow account, to subsidize these lower monthly payments. This account covers the difference between the reduced payment the borrower makes and the actual payment amount based on the permanent interest rate. While the borrower benefits from lower payments initially, the underlying loan’s principal and interest are still calculated based on the full, permanent rate.

The Mechanics of a 2/1 Buydown

If a borrower secures a 30-year fixed-rate mortgage with a permanent interest rate of 7%, the 2/1 buydown modifies this rate for the initial two years. During the first year, the effective interest rate for the borrower would be 5% (7% – 2%). In the second year, the rate would increase to 6% (7% – 1%).

The difference between the payment calculated at the permanent rate and the reduced payment is funded by a lump sum placed into a buydown account, often an escrow account, at closing. Each month, funds are drawn from this account to supplement the borrower’s payment, ensuring the lender receives the full amount due based on the permanent rate. For example, if the full monthly payment at 7% is $1,799, and the reduced payment at 5% is $1,432, the buydown account covers the $367 difference. If the loan is paid off or refinanced before the buydown period ends, any remaining funds in the escrow account are typically returned to the party who funded it.

Key Parties and Their Contributions

Several parties can contribute to funding a 2/1 buydown. Home sellers, home builders, or sometimes the lender itself, often bear the cost of the buydown. This financial incentive makes the property more appealing to prospective buyers, especially in markets with higher interest rates or when a seller wants to move inventory quickly.

The cost of the buydown is usually negotiated as part of the home purchase agreement. It represents the total amount needed to cover the difference in payments over the two-year period. Borrowers are typically the recipients of the reduced payments and do not usually fund the buydown themselves, though in some cases, they can contribute.

Navigating the Post-Buydown Period

After the two-year temporary buydown period concludes, the interest rate on the mortgage will revert to the permanent, agreed-upon rate for the remaining term of the loan. This means that the borrower’s monthly mortgage payments will increase to the full amount they qualified for at the outset.

Borrowers should anticipate and prepare for this payment increase. Financial planning should include accounting for the higher payments that will begin in the third year. Borrowers might consider strategies such as setting aside savings during the buydown period or ensuring their income can comfortably support the higher payment. Refinancing the loan is another option if interest rates in the market have dropped, allowing the borrower to secure a new, lower permanent rate, though this involves new closing costs and qualification.