What is 'Buydown'
A buydown is a mortgage-financing technique with which the buyer attempts to obtain a lower interest rate for at least the first few years of the mortgage, but possibly its entire life. The builder or seller of the property usually provides payments to the mortgage-lending institution, which, in turn, lowers the buyer's monthly interest rate and therefore monthly payment. The home seller, however, will usually increase the purchase price of the home to compensate for the costs of the buydown agreement.
BREAKING DOWN 'Buydown'
Buydowns are easy to understand if you consider them a mortgage subsidy made to the homebuyer on behalf of the seller. Typically, the seller contributes funds to an escrow account that subsidizes the loan during the first years, resulting in a lower monthly payment for the homebuyer. This lower payment allows the homebuyer to qualify more easily for the mortgage. Builders or sellers may offer a buydown option to help increase the chances of selling the property making it more affordable to buyers.
Buydown terms can be structured in various ways for mortgage loans. Most buydowns last for a few years, and then the mortgage payments increase to a standard rate once the buydown expires. 3-2-1 and 2-1 mortgage buydowns are two common structures.
In a 3-2-1 buydown the buyer pays lower payments on the loan for the first three years. These payments are offset by the buydown contribution made from the seller. For example, a homebuyer that has received a 6.75% fixed interest rate on a $150,000 loan for 30 years would have lower payments in the first three years. In year one they would pay 3.75% interest, in year two 4.75% and in year three 5.75%. In the years following the first three years their payments would increase to the standard rate of 6.75% or $973 monthly. While they received savings from the lower interest rate in the first three years, the difference in the payments would have been made by the seller to the lender as a subsidy.
A 2-1 buydown is structured in the same way however its discount is only available for the first two years. If a borrower received a $100,000 loan for 30 years at a 6.75% fixed interest rate, they could lower their payments in the first two years with a 2-1 buydown. In a 2-1 buydown they could pay 4.75% interest in year one and 5.75% interest in year two. In the years following, their payments would increase to the standard rate of 6.75% and they would pay $649 monthly. The savings they obtained in the first two years would have been offset by subsidy payments from the seller to the lender providing them with the two-year discount.