What Is a Buy Down on a Mortgage & How Does It Work?

A mortgage buydown is a financing technique that reduces the interest rate on a home loan, either temporarily or for the entire loan term. This strategy involves an upfront payment to achieve a lower rate, leading to reduced monthly mortgage payments. Buydowns enhance affordability for homebuyers, especially in high-interest-rate markets.

How a Mortgage Buydown Functions

A mortgage buydown uses an upfront payment, often called “points,” to lower a loan’s effective interest rate. One point typically equals one percent of the total mortgage amount; for example, on a $300,000 mortgage, one point costs $3,000. This fee acts as prepaid interest, resulting in lower monthly principal and interest payments. The interest rate reduction commonly ranges from 0.125% to 0.25% per point.

Buydown funds are placed into an escrow account at closing. Monthly disbursements from this account supplement the borrower’s payments, covering the difference between the actual interest rate and the reduced rate. For instance, if a loan’s actual rate is 7% but is bought down to 4% in the first year, the escrow account covers the 3% difference.

The cost of a buydown generally approximates the total interest savings over the buydown period. While the upfront cost can be substantial, it leads to reduced monthly outlays, which can free up cash flow for other initial homeownership expenses. Borrowers should calculate their break-even point, where accumulated monthly savings equal the upfront cost, to determine the financial advantage.

The Internal Revenue Service (IRS) generally considers discount points as prepaid interest. If these points are paid to reduce the mortgage interest rate on a principal residence, they may be deductible in the year paid, provided certain conditions are met. These conditions include the loan being secured by the principal residence, the payment of points being an established business practice, and the amount not exceeding what is generally charged. Otherwise, points are typically deducted over the life of the loan and reported on Schedule A (Form 1040) as an itemized deduction.

Variations of Mortgage Buydowns

Mortgage buydowns primarily come in two forms: temporary and permanent. The distinction lies in how long the reduced interest rate applies to the loan.

Temporary Buydowns

Temporary buydowns, such as the 2-1 buydown or 3-2-1 buydown, provide a reduced interest rate for a set initial period, typically one to three years. For a 2-1 buydown, the interest rate is reduced by 2% in the first year and 1% in the second year, before returning to the original note rate in the third year. For example, a 7% loan would have a 5% rate in year one, 6% in year two, and then revert to 7% in year three. This structure offers lower initial payments, helping homeowners adjust to new expenses during early homeownership.

A 3-2-1 buydown extends this concept over three years. The interest rate is reduced by 3% in the first year, 2% in the second year, and 1% in the third year. After the third year, the interest rate reverts to the original, full rate. For instance, a 7% loan would see rates of 4% in year one, 5% in year two, 6% in year three, and then the full 7% from year four onward. Funds for these temporary reductions are held in an escrow account and used to subsidize the monthly payments.

Permanent Buydowns

A permanent buydown, commonly referred to as paying “discount points,” reduces the interest rate for the entire life of the loan. When a borrower pays discount points at closing, they prepay a portion of the interest to secure a lower rate from the outset. This reduction is permanent, applying to all future payments for the duration of the mortgage, unless refinanced. Each discount point, typically costing 1% of the loan amount, can reduce the interest rate by approximately 0.125% to 0.25%. While requiring a larger upfront investment, permanent buydowns can lead to significant interest savings over the full term of a long-term mortgage.

Sources of Buydown Funds

The funds for a mortgage buydown can originate from several parties: the borrower, the home seller, or a builder or developer. Regardless of the source, the funds are typically deposited into an escrow account at closing.

Borrower-Paid Buydowns

When the borrower pays for a buydown, they contribute the upfront cost directly at closing to secure a lower interest rate. This can be a strategic choice for borrowers with sufficient liquid assets who plan to remain in the home long enough to realize savings that exceed the initial cost.

Seller-Paid Buydowns

A home seller may offer to fund a buydown as an incentive to attract buyers or to facilitate a quicker sale, especially in a competitive market or when interest rates are high. A seller-paid buydown allows the seller to credit a portion of their proceeds towards reducing the buyer’s mortgage interest rate. This can be a more appealing option than reducing the home’s listing price, as it directly addresses affordability for the buyer without devaluing the property. Such concessions are treated as if paid by the buyer for tax purposes, meaning the buyer can deduct eligible points, though they must reduce their home’s basis by the amount of seller-paid points.

Builder-Funded Buydowns

Builders and developers frequently offer buydowns, particularly for new construction homes, to encourage sales and clear inventory. The builder pays the upfront fees to the lender, reducing the borrower’s interest rate, either temporarily or permanently, as a marketing strategy. These builder-funded buydowns function similarly to seller-paid buydowns, with funds held in escrow and used to subsidize interest payments.