With Mortgage Rates Surging, Buydowns Are Ready for a Reboot

Home buyers are looking for ways to whittle down their mortgage rates. As a result, a once-popular home-selling tactic is making a comeback. It's called a temporary buydown, and it was widely used when mortgage rates were zooming upward in the late 1970s and early 1980s.

The revival of the temporary buydown is timely, as mortgage rates are at a two-decade high, with the Federal Reserve expected to raise the floor under mortgage rates twice more this year. Fewer people are buying homes because rising rates make homeownership unaffordable. In some markets, negotiating power is even shifting from sellers to buyers.

In these conditions — when interest rates are rising and home sellers must make an effort to lure buyers — temporary buydowns can flourish. It's time to dust them off and put them to use.

How do you buy down a mortgage rate?

A temporary buydown reduces the home buyer's monthly payments in the first year, or sometimes in the first two or three years. Instead of making the mortgage's full monthly payments from the get-go, the home buyer will make discounted payments for a year or more.

This is accomplished by subsidizing the interest rate that the borrower pays. For example, let's say a buyer gets a mortgage at a 7% interest rate, with a one-year buydown. Because of the buydown, the monthly payments in the first year are based on a 6% interest rate before rising to 7% thereafter.

If the borrower got a $300,000 mortgage in this hypothetical example, the buyer's principal-and-interest payments in the first year would be $1,799 a month, before rising to $1,996 a month in years two through 30. A buydown under these terms would save the borrower about $197 a month in interest in the first year, for a total of $2,367.

Traditionally, most temporary buydowns are paid for by home builders and home sellers as a closing cost equal to the buyer's interest savings. In the example above, the buyer saves $2,367, and the seller deposits that amount into a custodial account at closing. The loan servicer draws from the account every month to make up the difference between the full loan payment and the discounted bill the homeowner is paying.

The twist these days is that some lenders are offering temporary buydowns as a means of competing for business when there are fewer mortgages to write. When comparing lenders, this is a feature worth watching for.

What the buyer gets out of it

"Buydowns were a routine affair when I got into the real estate business in 1978," says Lou Barnes, senior loan officer with Cherry Creek Mortgage in Boulder, Colorado. Mortgage rates were rising fast in those days, as they are now, and buydowns were designed to ease the buyer's transition from a lower interest rate or cheaper rent, Barnes says.

Nowadays, temporary buydowns appeal to first-time home buyers who are shocked by the speed at which mortgage rates have risen, and who will deplete their savings on the down payment and closing costs. The temporary payment reduction allows borrowers to replenish savings or spend the money on home upgrades.

"You know how it is when you buy a home: You might want to buy new carpeting, new appliances — what it takes to make it your home," says Bill Banfield, executive vice president of capital markets for Rocket Mortgage.

Rocket is paying for one-year buydowns through the end of 2022, Banfield says, with a product the company calls Inflation Buster. New American Funding offers lender-paid buydowns, too, said Ben Lane, New American's managing director of editorial, through email. And other lenders have recently begun to market buydowns paid by sellers.

Buydowns can last longer than one year, allowing borrowers to extend their savings:

• A 2-1 buydown reduces the interest rate by two percentage points in the first year, then by one percentage point in the second year, before rising to the full rate after that.

• A 3-2-1 buydown lasts three years, with the interest rate reduced by three percentage points in the first year, by two percentage points in the second year and by one percentage point in the third year.

• With a 1-1-1 buydown, the rate is reduced by one percentage point for three years.

What the seller gets out of it

Temporary buydowns are "older than bell-bottoms," Banfield says, and there are signs that they are coming back into fashion as negotiating mojo shifts from sellers to buyers. The reason: Buydowns are a time-tested way to entice reluctant buyers.

A seller may offer a buydown instead of dropping the price. That way, the seller gets to brag about getting the desired price while the buyer saves money.

For example, let's say the buyer and seller are $7,000 apart after days of haggling. A temporary buydown resolves the impasse:

• The buyer pays the price the two sides are stuck at: $7,000 more than the buyer wants to pay.

• As a compromise, the seller pays for a 2-1 buydown on the buyer's $300,000 mortgage at a 7% interest rate. The 2-1 buydown saves the buyer $6,992 over the first two years of the loan. That $6,992 comes out of the seller's proceeds at closing — equivalent to a price cut, but invisible to the neighbors.

Negotiating a buydown

Either side can suggest a buydown. The seller can offer one proactively, as a competitive tactic. The buyer can request one as a seller's concession.

The lender must qualify the borrower at the full interest rate, which requires the lender to determine that the borrower can afford to repay the loan after the rate reductions have run out.

Government-sponsored mortgage companies Fannie Mae and Freddie Mac impose limits on seller concessions, including temporary buydowns. Limits vary, depending on down payment size.

Fannie and Freddie also restrict temporary buydowns to a maximum of three years. And to soften payment shock, the effective interest rate can go up only one percentage point each year. So the borrower's effective rate can't jump from 5% to 7%; it would have to go from 5% to 6% for a year before settling at 7%.

How buydowns differ from ARMs

A temporary buydown resembles an adjustable-rate mortgage because the borrower starts out making payments at one interest rate and later makes payments at another interest rate. But a buydown is not an ARM.

A key difference is what happens with the interest rates. On an ARM, the interest rate and the monthly payments can change periodically for the life of the loan. With a buydown, the interest rate never changes. Instead, the seller (or sometimes the lender) pays part of the borrower's interest payments in the first year or two or three, but the underlying note rate remains the same.

One argument in favor of ARMs is that they last longer and can result in greater savings, at least in the first five years, says Carolyn Morganbesser, assistant vice president of mortgage originations for Affinity Federal Credit Union in New Jersey.

"The ARM is going to get you into your home; it's going to give you the lowest possible payment at this given time," Morganbesser says.

While that may be true, one drawback to ARMs is that a seller can't offer them as a concession. Morganbesser says that in her area, this objection is irrelevant right now because it's still strongly a seller's market, so sellers have little incentive to offer concessions.

But in some places away from the East Coast, sellers already are competing for a dwindling pool of willing buyers. In these markets where buyers have the power to pick and choose, sellers might be inclined to offer buydowns.

How buydowns differ from discount points

Paying discount points is a way to permanently reduce the interest rate, and therefore the monthly payments. Sellers can pay discount points as a sales incentive. But with discount points:

• The monthly savings are less. Paying one discount point — equal to 1% of the loan amount — typically reduces the interest rate by about one-quarter of a percentage point.

• Even though the monthly savings aren't much to boast about, the cumulative savings can be substantial over several years.

• It usually takes six or seven years of regular payments for the accumulated savings to exceed the upfront cost.

"If you sell or refi before those six years, you leave money on the table," Barnes wrote in an email.

In contrast, the buyer's savings from a temporary buydown equal the seller's upfront cost in one to three years.

A welcome return to normality

The imminent revival of temporary buydowns is a harbinger of a more traditional housing market in which sellers and their real estate agents are no longer sorting through a dozen desperate offers for every house.