What Is a Mortgage Rate Buydown and How Does It Work?

A mortgage rate buydown is a financial arrangement where an upfront payment reduces the interest rate on a home loan, either for an initial period or for the entire loan term. This strategy aims to lower the borrower’s monthly mortgage payments, making homeownership more accessible. It can be particularly relevant in periods of higher interest rates, offering a way to manage the cost of borrowing.

Understanding Mortgage Rate Buydowns

A mortgage rate buydown functions by placing an upfront sum of money into an escrow account, which is then used to offset a portion of the borrower’s monthly interest payments. The key parties involved typically include the borrower, the lender, and often a third party who contributes the buydown funds, such as the home seller, a builder, or sometimes the borrower themselves.

The funds contributed for the buydown are held in a custodial escrow account by the lender. Each month, a portion of these escrowed funds is drawn to supplement the borrower’s payment, covering the difference between the reduced interest rate and the loan’s actual, higher note rate.

Types of Mortgage Rate Buydowns

Mortgage rate buydowns primarily come in two forms: temporary and permanent, each with distinct mechanics. Temporary buydowns reduce the interest rate for a set period, commonly one, two, or three years, before the rate reverts to the original, fixed note rate. Common structures include the “2-1 buydown,” where the interest rate is reduced by 2% in the first year and 1% in the second, and the “3-2-1 buydown,” which offers a 3% reduction in the first year, 2% in the second, and 1% in the third.

In contrast, a permanent buydown involves paying “points” upfront to lower the interest rate for the entire duration of the loan. Each “point” typically represents 1% of the total loan amount and is paid at closing. For instance, one point on a $400,000 loan would cost $4,000.

Financial Implications of a Buydown

This reduction can lead to substantial savings on monthly payments, making homeownership more affordable, especially in the initial years. For example, a temporary buydown means the borrower pays less interest in the early stages, freeing up cash flow.

The cost of a buydown varies depending on its type and the extent of the rate reduction. For temporary buydowns, the upfront lump sum deposited into escrow generally equals the total interest savings over the buydown period. For permanent buydowns, the cost is calculated by the number of discount points purchased, with each point typically costing 1% of the loan amount and reducing the interest rate by approximately 0.125% to 0.25%. While the upfront cost increases closing expenses, the reduced interest rate can lead to significant overall interest savings across the loan’s lifetime. However, the actual long-term savings depend on how long the borrower keeps the loan, as the break-even point where savings outweigh the upfront cost can vary.

Important Considerations for Buydown Programs

Eligibility for a buydown often depends on the type of property and loan, with many programs being applicable to fixed-rate mortgages for primary residences or new construction homes. While buydowns are sometimes offered by sellers or builders as incentives, the borrower is still qualified for the mortgage based on the full, un-bought-down note rate, not the temporarily reduced rate.

A crucial aspect of temporary buydowns concerns the handling of unused funds in the escrow account if the loan is paid off, sold, or refinanced before the buydown period concludes. In such cases, any remaining funds in the escrow account are typically returned to the party who initially contributed them, which could be the borrower, seller, or builder. Some agreements may specify that unused funds are applied as a principal reduction to the loan balance. The buydown agreement, a separate document from the mortgage note, outlines these terms and the borrower’s continued obligation for the full payment if buydown funds become unavailable.