What Is a 3-2-1 Buydown and How Does It Work?

A 3-2-1 buydown offers a temporary reduction in a mortgage interest rate for homebuyers. This financing technique aims to make homeownership more accessible by lowering initial monthly payments. It serves as a temporary interest rate subsidy, distinct from a permanent rate reduction achieved through discount points. This approach can be particularly appealing when prevailing interest rates are elevated, allowing buyers to ease into their mortgage obligations.

Defining the 3-2-1 Buydown

A 3-2-1 buydown is a temporary mortgage financing option that reduces the initial interest rate for the first three years of a loan. For the first year, the interest rate is 3% below the original, agreed-upon note rate. This provides a substantial decrease in early mortgage payments.

In the second year, the interest rate is reduced by 2% from the original rate, while the third year sees a 1% reduction. After the third year, the interest rate reverts to the original note rate for the remainder of the loan term. This structured increase allows borrowers to gradually adjust to higher payments.

The funding for a 3-2-1 buydown is provided by parties other than the homebuyer. Sellers or homebuilders frequently cover the cost as an incentive to attract buyers or facilitate sales, especially in challenging market conditions. The mortgage lender or an employer relocating an employee might also fund the buydown. This arrangement makes the property more appealing without reducing the sale price.

How a 3-2-1 Buydown Functions

A 3-2-1 buydown involves a dedicated escrow account. The funding party deposits a lump sum into this account at the loan’s closing. This upfront payment covers the difference between the borrower’s reduced monthly payment and the full payment calculated at the original note rate. The lender manages this escrow account, drawing funds from it each month.

Each month, a portion of the deposited funds is released from the escrow account to supplement the borrower’s payment. For example, if the original interest rate is 7% on a $300,000 loan, the first year’s rate would be 4%, the second year 5%, and the third year 6%. The escrow account covers the difference in principal and interest between the actual payment and what the payment would be at the full 7% rate for those initial three years.

Should the loan be refinanced or paid off early during the buydown period, any remaining funds in the escrow account are applied as a principal reduction to the loan balance. Unused funds are not lost and may be returned to the borrower or funding party if the mortgage is paid off early.

Purpose and Financial Outcomes

A 3-2-1 buydown serves purposes for both the funding party and the homebuyer. From a seller’s or builder’s perspective, it acts as an incentive to attract buyers. This financing tool can help move properties without requiring a direct reduction in the property’s listing price. It provides a financial concession that makes a home more attainable for a wider range of buyers.

For homebuyers, the financial outcome is lower monthly mortgage payments during the initial three years of homeownership. This reduction can ease the financial burden after purchasing a home. It allows individuals to adjust to the responsibilities of homeownership and potentially build savings or address other financial goals.

The structure of gradually increasing payments helps homebuyers transition to the full mortgage payment as their income potentially grows over time. While the buydown offers temporary relief, borrowers should be prepared for the payment increase in the fourth year. This requires careful financial planning to ensure affordability once the reduced-rate period concludes.