Temporary Rate Buydowns
Temporary interest rate buydowns are a good option for those who want to get a mortgage and start with a lower payment than the going interest rate. Temporary interest rate buydowns are misunderstood by many realtors and potential home buyers. There are options that allow a buyer to reduce their rate for 3, 2, or 1 year(s). The costs typically need to be paid by the seller in a form of seller concessions or in the form of a lender credit (higher interest rate will equal a higher lender credit). Current mortgage interest rates are expected to be at about their peak. The Feds are anticipated to reduce their rate hikes and allow markets to settle. The Fed Rate is indirectly related to mortgage rates. This means that an opportunity to refinance is likely in the next year or two to get into a lower interest rate permanently.
Types of buydowns
There are a few different types of temporary rate buydowns available. Temporary rate buydowns may allow a buyer to pay a lower payment for 1 to 3 years depending on how the buydown is structured. First is a 1-0 buydown, this is when an interest rate is bought down by one percent for one year. There is a 1-1 buydown, this is when an interest rate is bought down by one percent for two years. Then there is a 2-1 buydown, this is when the interest rate is bought down for two years. The first year the rate is bought down by two percent and the second year the rate is bought down by one percent. There is also a 3-2-1 buydown. This buydown allows the rate to be bought down by three percent the first year, two percent the second year, and one percent the third year.
Why would anyone use a temporary rate buydown?
Temporary rate buydowns are becoming more popular across the country as markets adjust to higher interest rates. More homes are on the market, which allows a buyer to have more options to choose from. It also means that many sellers are willing to contribute to buyer’s closing costs. If a seller agrees to pay toward the buyer’s closing costs, the buyer may have an option to use the temporary rate buydown. The seller concessions need to cover the cost of the buydown or the interest rate needs to come with a credit to assist in covering the costs of the buydown.
There are potential homebuyers who either want to buy a house or are ready to upgrade. They have been held back from the higher prices and interest rates that equate to higher payments. They may now be on the fence about buying. Many want to upgrade or downsize but have been deterred by the inventory and active buyer fiasco from the last couple years. Temporary rate buydowns may be the solution to help these types of buyers live out their goals.
Many potential buyers want to ease into a larger housing payment. Former renters may benefit from the temporary rate buydown as the costs of rent seem to continually rise. Others anticipate wage increases and making gradual payment increases is more feasible for their scenario. There is a larger selection of homes available to choose from right now on the market. When rates drop again, and they will, the housing market will pick up. This has been a cycle for decades and is expected to continue.
When interest rates drop, many buyers will have an opportunity to refinance. The temporary rate buydown allows these buyers to purchase a home and have a lower payment while waiting for rates to drop.
How a Temporary Rate Buydown Works
Let’s use an example of a 2-1 buydown to illustrate this better. Let’s say the base interest rate (Note Rate) is 5.875%. This means the buyer will need to qualify for the loan with a 5.875% interest rate. 5.875% is what the regular payment terms of the loans would be based on. With a 2-1 buydown, the buyer will pay their first year’s payment based on a 3.875% interest rate (2% less than 5.875%). The second year, the payment would be based on a 4.875% interest rate (1% less than 5.875%). Then starting the third year, the payment would be based on the 5.875% interest rate.
The payments will be substantially lower for the first couple of years. Interest rates are anticipated to drop within the next year or two by most analysts. This may allow an opportunity to refinance into a permanent lower interest rate. However, every buyer should be prepared to take on the full payment with the note rate if using the temporary rate buydown program.
Now what if I have a temporary rate buydown and I refinance before my buydown terms are over? Where does the money from the buydown go? Upon closing your loan, the funds for the temporary rate buydown are deposited into a buydown account. The funds are withdrawn from this account each month to make up the difference of the payment based on the reduced interest rate. Money will be in the buydown account until the buydown period is complete. If you sell or refinance, the funds leftover in your account will be applied to the remaining principal. There is no risk of losing the funds in your buydown account if you refinance or sell your home before the temporary buydown period is complete.
Detailed 2-1 Buydown Scenario
Here is an idea of what a 2-1 buydown would look like with a 740+ credit score:
Loan Amount: $400,000
Purchase Price: $500,000
Interest Rate: 5.875% (as of 12/1/2022 no points, in fact, it would be a .125% lender credit which equates to a $500 lender credit in this scenario)
APR: 5.759% (this is not an error that the APR is less than the interest rate. The APR is less because of the temporary buydown reduced the overall costs of the loan.)
Term: 30yr Conventional Fixed
Monthly Payment (Principal and Interest only, excludes taxes and insurance) at note rate of 5.875%- $2366.15
1st year payment at 3.875%- $1,880.95(P&I). Monthly savings $485.20. Annual savings- $5,822.40
2nd year payment at 4.875%- $2,116.83(P&I). Monthly savings $249.32. Annual savings- $2,991.84
Buydown cost ($5,822.40 + $2,991.84) = $8,814.24= 1.763% in seller concessions
The buydown costs would be paid by the sellers on an addendum to the purchase contract or could be covered by the lender in the form of a lender credit. To obtain a lender credit, the rate may be higher than the going rate. However, keep in mind that the going rate will vary between lending companies. Rates also can change multiple times in a day so understand that the current rates may be different than the ones given in the example.
What does this mean for sellers and realtors?
Sellers and realtors need to understand that the market is shifting to a buyers market. The days of multiple offers above asking price within a week of listing are gone. Sellers who want to sell their home in the current market are going to need to find ways to cater more to buyers. This means many sellers are going to start offering to pay for the buyer’s closing costs, or reduce the price of their homes in order to attract buyers and make their homes more affordable. I feel this is going to be the scenario for about the next year.
Sellers should also be aware of the temporary rate buydowns and how they work. In many cases, a temporary rate buydown will be a bigger incentive than just dropping the price on a home. This is because the home becomes more affordable to the buyer for the duration of the rate buydown. It also allows the buyer some time to adjust to the payment and may even allow them to refinance to a lower payment when rates do drop. Every person’s scenario is going to be different so don’t be afraid to communicate your goals and concerns with your realtor or loan officer. It might make all the difference in selling your home or not.
Conclusion
Temporary rate buydowns are an attractive product because it allows the buyer to enter the housing market with a lower payment. In turn, the borrower may use the monthly savings toward furniture, upgrades, or savings to prepare for potentially higher payments. Interest rates are expected to become lower by many analysts over the next year or two, which may allow those who use a temporary rate buydown to refinance into a lower interest rate and a lower monthly payment permanently.
The cost of the temporary rate buydown will vary depending on the program, interest rate, and loan amount. The costs need to be covered by the seller or in the form of a lender credit. If you are able to refinance or sell within the temporary rate buydown period, the remainder of the funds that are in your buydown account will be reimbursed to you in the form of a principal reduction. This product is a great alternative to prospective homebuyers who want a lower monthly payment over the temporary buydown period.