The Real Deal on Mortgage Buydowns: Pros, Cons, and More

Key Takeaways

• A mortgage buydown is when someone buying a home or refinancing their mortgage pays for interest points upfront, which can slash their monthly payment and reduce their interest rate.

• Depending on the mortgage buydown type, the rate decrease could be permanent or temporary.

• Generally, a mortgage buydown works best for those who buy a home they expect to own for more than a couple of years, and whose income will increase in the years to come.

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. 

What is a Mortgage Buydown?

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.

How Does a Mortgage Buydown Work?

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. 

Benefits and Considerations of a Mortgage Buydown

There are advantages and considerations that one should consider when mulling a mortgage buydown, including:

• Lower initial payments. A reduced interest rate can slash the homeowner’s monthly payment, freeing up money for other investments, long-term expenses, or financial objectives. The type of buydown chosen will determine whether the lowered costs are temporary or permanent.
• Financial planning. Another benefit to mortgage buydowns is that they can help with long-term financial planning. The homeowner knows what their rate will be. 
• Additional costs. Mortgage buydown considerations include the fact that there will be additional expenses, as well as long-term costs. Once the buydown ends and the rate goes back up, it can be challenging to keep up with payments without an income increase.
• Long-term costs. Depending on the mortgage buydown’s structure, not only may the lower interest rate be temporary, but the increased mortgage payment at the low-rate period’s end could put a strain on the homeowner’s budget. 

Mortgage Buydown vs. Traditional Mortgage

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.”

Is a Mortgage Buydown Popular?

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.

What are Some Types of Mortgage Buydowns?

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.

Should You Take a Mortgage Buydown?

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. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

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.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

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.