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

A mortgage interest rate buydown offers a way to temporarily reduce initial mortgage payments, providing financial flexibility during the early stages of homeownership. This financing technique can be helpful in market environments with higher interest rates, easing the burden for homebuyers. The interest rate reverts to its original level after a set period.

Understanding the 3-2-1 Buydown

A 3-2-1 buydown is a temporary mortgage interest rate reduction. It provides a stepped decrease in the interest rate over the first three years of the loan term. In the first year, the rate is reduced by three percentage points below the original note rate. The reduction lessens to two percentage points in the second year, and one percentage point in the third year. After this three-year period, the interest rate reverts to the full, original rate for the remainder of the mortgage term.

The Mechanics of a 3-2-1 Buydown

This buydown method directly impacts monthly payments by progressively adjusting the interest rate. For instance, if a mortgage has an original fixed interest rate of 7%, a 3-2-1 buydown would apply a 4% rate in the first year, 5% in the second, and 6% in the third. From the fourth year onward, the interest rate returns to the original 7%.

This tiered rate structure results in lower monthly payments during the initial three years. For example, on a $300,000 mortgage at an original 7% rate, the monthly payment would be lower in year one, then increase in year two and again in year three, before settling at the full payment in year four. This gradual increase allows borrowers to adjust their finances, making the transition to the full mortgage payment smoother.

Parties Involved and Funding

The cost associated with a 3-2-1 buydown, representing the difference between the reduced payments and the full payments over the buydown period, is typically paid upfront. This upfront payment is often covered by a third party, such as a home builder, the seller of the property, or occasionally the mortgage lender. These parties may offer to fund a buydown as an incentive to attract buyers or facilitate a property sale.

Funds for the buydown are usually placed into an escrow account at closing. Each month during the temporary buydown period, a portion is drawn from this account to supplement the borrower’s reduced payment. This ensures the lender receives the full payment based on the original rate, while the borrower benefits from the temporarily lowered interest rate.

Key Borrower Considerations

Borrowers must qualify for the mortgage based on the full, un-bought-down interest rate. Lenders assess a borrower’s ability to afford the loan at the original, higher rate to ensure financial stability once the temporary reduction period ends. This qualification requirement is important because monthly payments will increase significantly after the three-year buydown period concludes, reflecting the full interest rate.

Borrowers should plan for this payment increase and ensure their financial situation supports the higher obligations. Refinancing the loan before the buydown period ends is a possibility, but it is not guaranteed and depends on future market conditions and the borrower’s financial standing. If the loan is paid off or refinanced early, any remaining escrow funds are typically returned to the party who initially funded the buydown.