It is important for real estate investors and those who wish to enter the market to understand mortgage buydowns, including their benefits and considerations, and how they compare with traditional mortgages.
Here is the mortgage buydown: what it is and how it works.
A mortgage buydown is a financing technique in which a homebuyer pays for interest points upfront in exchange for a lower loan interest rate.
A buydown is usually offered by the builder or seller to help heighten opportunities to sell the property by rendering it more affordable.
There is technically no cap on how many points can be bought on a mortgage. However, the number of points an individual can purchase can hinge on the mortgage type and loan terms. How much each discount, or point, costs depends on the loan amount. In some instances, a buyer may opt to buy enough discount points to lower their interest rate over the loan’s life. By garnering a buydown loan, the home buyer pays an even bigger amount up front that impedes their rate, and therefore their monthly mortgage payments, from ever rising.
While most buydowns are negotiated between lenders and buyers, sellers may also provide a buydown to incentivize the individual to buy the property. In addition, builders may also offer a buydown. Usually, a builder will make upfront payments to get early buyers to secure properties in their newly constructed communities. Such builders are generally less inclined to offer such an incentive once the community is up and running.
To reduce their rate and monthly payment, someone buying a home or refinancing their mortgage can purchase discount points at closing to prepay mortgage interest. The property’s seller or builder typically makes payments to the mortgage lender, which lowers the rate, and thus the monthly payment.
Every discount point costs 1% of their loan amount. Buying one point on a $350,000 loan would cost $3,500 upfront, for example. However, the amount by which the rate is lowered per point depends on the lender, and the rate reduction is not necessarily 1:1. Purchasing one point could drop one’s interest rate, for example, by 0.50% or 0.375% instead of the full 1%.
It is generally a good idea to check out multiple lenders to compare rates and buydown options.
There are advantages and considerations that one should consider when mulling a mortgage buydown, including:
Overall, traditional mortgages have more stability, while mortgage buydown allows for a lower interest rate, which can be beneficial for someone with a specific financial situation.
Mortgage buydowns began surging last fall amid increased interest rates and a cooling housing market, which caused an increased number of home sellers to lure buyers by paying for a temporary drop in the buyer’s mortgage interest rate. As rates rose to 7 percent, the buydown helped to mitigate some of the sticker shock buyers were experiencing.
So, while rate buydowns have been around for years, they generally come into play under those market conditions. In fact, some of the nation’s biggest lenders, including Guaranteed Rate, United Wholesale Mortgage, and Rocket Mortgage began marketing the technique last year, with Rocket Mortgage calling its mortgage buydown program an “Inflation Buster.”
Overall, traditional mortgages remain more popular than mortgage buydowns. However, whether a mortgage buydown is suitable for an individual depends on the homeowner’s financial situation. Whomever is interested in buying down their mortgage should first calculate their breakeven point to see whether it is worth the upfront investment.
Depending on the mortgage buydown type, the rate decrease could be permanent or temporary.
With a permanent rate reduction, the interest rate discount covers the life of one’s loan, providing the homeowner with a reduced monthly payment during the whole amortization schedule.
With what is called a 3-2-1 buydown, the interest rate reduction is temporary – it begins low and rises incrementally for the first three years. The rate is 3% lower the first year, 2% lower the second year, and 1% lower the third.
Beginning with the fourth year and continuing throughout the life of the loan, the rate increases to the standard rate. If a loan’s standard rate is 7%, for example, the rate would be 4% the first year, 5% the second, 6% the third, and 7% in each ensuing year.
Here, the money paid up front is placed into an escrow account, to which the seller contributes. Every month, a sum equal to one’s rate drop is withdrawn from that account and put toward one’s payments. Ultimately, the homeowner will still pay the same for the mortgage as they would sans the buydown.
There is also a 2-1 buydown in which the interest rate is cut by 2% in the first year, and 1% in the second. Subsequently, the rate goes up in the third year and remains the same for the balance of the loan term.
As with a 3-2-1 buydown, funds obtained at closing will be placed into an account from which money is deducted monthly. In the end, the homeowner will pay the entire amount for the mortgage, just as they would if they had not made upfront payments.
Whether it makes sense to go with a mortgage buydown when purchasing a home can hinge on the rate for which the buyer qualifies. Generally, a mortgage buydown works best for those who buy a home they expect to own for a long time and whose income is expected to increase in the years to come. The reason is because the longer a home is owned, the more likely it will be that the homeowner, after buying discount points, will experience the full benefit of interest savings.
If the house is sold too soon, the homeowner will not reach the point where money saved due to the reduced rate begins to exceed the cost of purchasing points upfront.
For example, if a new home is bought with a $400,000 loan, purchasing a single point for $4,000 permanently decreases the homeowner’s rate from $2,903 to $2,771. Here, it would take about two-and-a-half years for the $132 in monthly savings to reach the $4,000 paid for the point. If the homeowner intends to remain in the house for over two years, interest savings will continue to pile up.
A buydown could also work for those who wish to get a mortgage without markedly raising the home’s purchase price or draining their bank account.
Conversely, taking a mortgage buydown may not be the best move if, before the two-year mark, the homeowner must relocate before recovering the cost, or if their wages will likely be stagnant, or even decrease, in the future.
To determine whether a buydown is appropriate, the breakeven point must be calculated. The breakeven point is how much time it will take to recoup the discount points’ cost. The calculation calls for dividing the cost of the discount points by the monthly savings.
Note that there are ways to invest in real estate in which a mortgage buydown is unnecessary. Leading alternative investment platform Yieldstreet, for example, offers a Growth & Income real estate investment trust that aims to make debt and equity payments in a mix of commercial real estate in key U.S. markets.
Along with asset classes such as art and transportation, real estate is a type of alternative investment. Besides the potential for regular monthly income, investments in real estate can help diversify portfolios, which, in turn, can mitigate overall risk and volatility.
Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
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In some cases, this risk can be greater than that of traditional investments.
This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.
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Depending on their financial situations, real estate investors and homebuyers seeking a respite from lofty interest rates have as an option a mortgage buydown, which would serve to lower the rate and monthly payment.
However, a buydown is not a good fit for everyone, and there are ways to invest in real estate in which the process is unnecessary.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.