What is a mortgage rate buydown?
5 min read
Written by Peter Khoury
Learn the fundamentals of buying down your mortgage's interest rate, how it works, the different types of buydowns that are offered, and whether or not a mortgage buydown is right for you.
A mortgage rate buydown, also called an interest rate buydown, is a mortgage financing technique where a buyer pays discount points at closing, enabling them to obtain a lower interest rate.
An upfront payment of discount points, also known as mortgage points or prepaid interest points, is a one-time fee that is applied to the mortgage at closing.
If discount points are used, the interest rate will be reduced for a period of time dependent on the type of buydown you opted for, with permanent buydowns affecting the entire life of your loan, regardless of term.
Mortgage rate buydowns have become a viable strategy for borrowers to insulate themselves against the rising mortgage rates we’ve seen so far in 2022 by reducing their interest payments.
What are "discount points" or "mortgage points"?
First, it’s important to understand what a point is.
One “point” in most cases costs to 1% of the loan amount (500,000 loan = $5000 = 1 point).
Discount points, sometimes referred to as mortgage points, are discounts you can purchase from your lender through a one-time purchase at closing that reduces the interest rate on your mortgage loan. Not to be confused with origination points, another type of mortgage point that instead compensates loan officers.
In the majority of cases one discount point is equal to a 0.25% reduction on your interest, so one point would lower a mortgage rate from 6% to 5.75% for the life of the loan, or whatever duration was negotiated.
The amount that you’ll get discounted can vary amongst lenders. For instance, one discount point doesn’t always reduce the rate by .25%, sometimes it will reduce the interest rate by more or less, depending on the lender.
What is a 3-2-1 buydown?
The 3-2-1 buydown is a financing method that allows you to temporarily lower the interest rate on your mortgage for the first three years of the loan, paying incrementally higher interest rates from year to year until the full interest rate is brought back for the fourth year.
The interest rate is reduced by 3%, 2%, and 1% for the respective years it’s active, hence the 3-2-1 buydown name.
It is more commonly used when interest rates are high in order to get a reduced rate, you'll have to pay an upfront cost at closing, called a buydown fee.
After the third year, you will be paying the full rate for the remainder of your mortgage.
What is a 2-1 buydown?
The 2-1 buydown is another mortgage financing method that allows borrowers to lower their interest rate for the first year of the loan, with a slightly higher rate on the second year, and returning to full interest on the third year and beyond.
Again like the 3-2-1 buydown, this often comes in the form of a 2% discount in the first year, and a 1% in the second, returning to the real interest rate in the third.
Seller Funded Buydown
Home buyers who might not otherwise be able to qualify for a larger mortgage or a more costly home may be able to do so with the aid of a buydown that’s paid for by the seller of the home.
As interest rates maintain their highs and home prices remain steep, home sellers may find it difficult to find buyers — this seller buydown arrangement can be hugely beneficial to both parties.
It can benefit sellers by making it simpler and occasionally faster for them to sell their properties for a fair price.
What you should consider regarding mortgage buydowns
The core purpose of a mortgage rate buydown is to save money over the course of the loan.
If you are going to live in your home long enough that your savings on interest payments exceed the initial cost of the discount points, then its easy to see why you should get a buydown.
It’s important to check whether or not you’ll break-even on your buydown investment before locking in. To check simply take the upfront cost of the discount points, and compare that to your monthly savings on your interest rate. However many months it takes to get your lump payment back is your break-even period. If you plan on refinancing soon after your purchase, or if you plan on selling quickly — you’ll want to check your break-even period and see if a buydown is right for you.
The IRS also provides opportunities to write off a portion of your buydown on your taxes, if borrowers meet the stipulated qualifications — saving buyers who take advantage of buydowns yet another benefit.
With many types of buydowns to choose from, as well as opportunities for the seller to pay for the borrowers/buyers buydown from the proceeds of the home sale, in this high interest and high price environment — the benefits are obvious.