What Are Interest Rate Buydowns?

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Your interest rate is an essential piece of your loan puzzle. As a buyer, you have a wide range of options to choose from. Finding avenues to lower your overall interest rate is key to a successful home-buying process. One thing that has been drastically affecting the purchasing ability of prospective buyers is the high-interest rates we are currently experiencing due to the federal response to combat inflation. If you fall into this category, it may be time to explore an interest rate buydown. It gives you the opportunity to lower your interest rates and save a significant amount of money throughout the life of your mortgage. By understanding how interest rate buydowns work, you can take advantage of them to lower your mortgage interest rate.

What is an Interest Rate Buydown?

At its core, interest rate buydowns are when you pay a larger amount upfront to receive a lower interest rate on your mortgage. As the buyer, you purchase discount points that are prepaid upfront. These allow the lender to provide more favorable interest rates. There are several different forms of interest rate buydowns. Some are active throughout the entire duration of the mortgage, while others allow a reduced interest rate for a specified duration of time. The cost of these discount points depends on the amount of the loan. Typically, each discount point is equal to 1% of the entire loan amount. The interest rate deduction per discount point varies between lenders.

Who is Able to Buy Down a Mortgage?

In most cases, the buyer is the one who chooses to pay for discount points upfront to get a better interest rate but there are also situations where a seller or builder might offer to pay for discount points. Sellers will offer interest-rate buydowns in order to incentivize the purchase of the home. These often are in the form of a one-time payment into an escrow account that will pay for discount points throughout the mortgage. While having the seller pay for the buyers’ interest rate buydown is a major advantage, they will often include this cost in the final purchase price of the home. To incentivize home purchases in new developments, builders will sometimes offer to provide points towards an interest rate buydown. These are usually only found in neighborhoods that have recently been constructed in order to fill up their occupancy quicker. 

Forms of Buydowns

While most interest rate buydowns are throughout the duration of the mortgage, they can be negotiated with terms that are more favorable to your specific situation. For example, a 1-0 buydown lowers the interest rate by 1% for the first year. While this type won’t achieve the amount of savings with a permanent buydown, it is a valuable asset if you expect your income to increase in the near future. A 2-1 buydown is similar to a 1-0 buydown but instead sees the interest rate begin 2% lower than the contract rate the first year, 1% lower the second year, and then return to the full interest rate for the rest of the mortgage. Less common is the 3-2-1 interest rate buydown. This type sees the rate go from 3% less the first year, 2% the second, 1% the third, and the full interest rate for the rest of the loan term. 

There is also an option to purchase discount points that will evenly distribute and reduce the interest rate throughout the duration of the mortgage. The initial cost of an evenly distributed interest rate reduction is much higher than the other forms of buydowns, however, the savings that can be had over the life of the loan are considerably larger when compared to the other forms of buydowns. This type of interest rate buydown is recommended for those who intend on staying in the home for over 5 years. 

When Should You Buydown Your Mortgage?

Even with the advantages of an interest rate buy-down, it is crucial to consider your situation and contemplate if a buy-down will benefit you. If the seller or builder offers to provide you with discount points, it is beneficial so long as the home’s purchase price isn’t significantly increased. While interest rate buydowns can save you money in the long run, the initial expenditure can often be quite hefty. This is why interest rate buydowns are recommended to those with savings left over after paying the downpayment and closing costs. Because buydowns require money upfront to access savings in the long run, interest-rate buydowns are only feasible if the buyer owns the home for an extended duration. 

The Breakeven Point

When exploring if an interest rate buydown is right for you, you must consider the return on investment and find out if your buydown financially makes sense. To determine how much you will save, you must first determine how long it will take for your monthly savings to reach the cost of the discount points. To do this, simply divide the amount you spent on your discount points by your monthly savings. The result will show you the amount of time it will take for you to start earning your savings. If your breakeven point is longer than you plan on owning the house, you will not save any money using an interest-rate buydown. 

Restrictions on Buydowns

Unfortunately, there are some restrictions in place that limit the use of interest rate buydowns. Investment properties and cash-out refinance cannot utilize a buydown. To avoid overpriced homes, some states have limits on the number of discount points that can be purchased. Certain types of mortgages also have restrictions such as an adjustable-rate mortgage, which is only able to be used with plans that have an initial interest rate period of at least three years. Lastly, government-backed loans like an FHA loan are only able to use temporary buydowns if they are on a fixed mortgage. If you have an FHA loan, you cannot temporarily buy down your mortgage if you are getting an adjustable-rate mortgage or are refinancing, although, permanent buydowns are permitted.  

Take Control of Your Home Loan With Federal Hill Mortgage

If you are looking to purchase a home and take on a mortgage, do it with the confidence that comes with having a team of mortgage professionals in your corner. At Federal Hill Mortgage, we work closely with each of our clients to ensure that they get the best mortgage terms available. Considering taking advantage of an interest rate buydown? We can help you to get favorable terms and increase your monthly savings. Call or contact Federal Hill Mortgage to begin your home-buying journey today!

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