Today’s High-Rate Hero
With mortgage rates at their highest since 2007, securing an affordable and manageable home loan can seem like a daunting, nigh unto impossible, challenge. Temporary rate buydowns provide a strategic solution to navigate the challenges of high interest rates and offer an attractive and practical alternative for borrowers looking to optimize their mortgage options. Let’s delve into the advantages and mechanics of temporary rate buydowns to understand why some are calling them the best loan option for a high-rate environment.
An Alternative that Yields Savings Up to 3%
A trending practice in today’s high-rate environment is for lenders to recommend or require buyers to permanently buy down a rate. A lender may suggest a 100 bps buydown, or 1% of a loan (i.e., $4,000 on $400,000) to bring the rate down to a more manageable payment. While permanent rate buydowns provide respite from high monthly payments, they come with limitations, especially when considering the possibility of refinancing. Oftentimes it takes up to three or four years to break even on a permanent buydown and any unused portion of the buydown does not carry over to a refinanced loan.
A permanent buydown also does not have the same reduction power as a temporary rate buydown. A permanent buydown at 100 bps can reduce a loan by maybe .25-.75%. A temporary buydown can reduce a loan by up to 3%! That’s some real purchasing power savings!!
How It Works
A temporary rate buydown essentially functions as a form of prepaid interest. This financial arrangement involves an upfront payment from a third party, typically the seller, lender, or builder. The contributed amount reduces the borrower’s monthly mortgage payments, acting as a form of prepaid interest for the designated buydown period. This strategic approach not only provides immediate financial relief but also allows borrowers to manage their initial mortgage payments more effectively. As the buydown period progresses, the prepaid interest gradually diminishes until the borrower assumes full responsibility for the originated mortgage rate.
Common Temporary Buydown Terms
Temporary buydowns range from 1-3 years and can reduce rates by up to 3% per year. Because the cost of a temporary buydown is the prepaid interest amount, they become more expensive as the rate reduction and length of the buydown increases. As the loan amount and interest rate increase, the cost of the prepaid interest also rises. It is important to note that there are some loan level price adjustment (LLPA) increases if the lender or buyer ends up paying for a portion of the buydown. It doesn’t make much sense for a buyer to pay for a temporary buydown because they would be paying interest ahead of time. Here are some typical temporary buydown scenarios.
3-2-1 Temporary Buydown
A 3-2-1 temporary buydown decreases the rate by 3% in the first year, 2% in the second year, 1% in the third year, and the loan returns to its permanent fixed rate in year 4. For example, a 7.5% fixed rate would be at 4.5% the first year, 5.5% the second year, 6.5% the third year, and then back to 7.5% for year four. This is the most aggressive and expensive temporary buydown.
2-1 Temporary Buydown
A 2-1 temporary buydown decreases the rate by 2% in the first year, 1% in the second year, and is back to the fixed rate in year three. For example, a 7.5% rate would be at 5.5% in the first year, 6.5% in the second year, and then up to 7.5% in year three. This would be a comfortable mid-range option, especially for a conventional loan.
1-1 Temporary Buydown
A 1-1 temporary buydown decreases the rate by 1% in the first year and second year and returns to the fixed rate at year three. For example, a 7.5% rate would be at 6.5% in the first year, 6.5% in the second year, and then up to 7.5% in year three. This is a successful option when the third party has limited funds to commit to the buydown or for a jumbo loan where 1% can make a significant difference.
Unused Temporary Buydown Funds Can Be Rolled Over During Refinancing
One of the greatest advantages of a temporary buydown is that if you choose to refinance before the buydown term expires, your unused interest rolls over to your new loan. For example, if you refinance after two years, and your buydown covers three years, the remaining amount on the loan can be applied to your new loan as closing costs. Unlike permanent buydowns, your funds do not expire until you’ve used them all up!
Significant Payment Relief During First Years of a Loan
Temporary rate buydowns provide immediate relief by reducing the initial payments on a loan. This allows borrowers to manage their expenses more efficiently during the critical early years of homeownership. It is especially advantageous for a buyer needing to furnish or renovate a home, or for someone who expects their income to increase over the initial years of their loan. Compared to an adjustable-rate mortgage, a temporary buydown removes the uncertainty of rate increases and allows borrowers to plan their future finances.
What are the Downsides of Temporary Rate Buydowns?
While temporary rate buydowns provide short-term relief, borrowers must carefully consider the long-term cost implications once the buydown period ends. The gradual phasing out of the subsidy can lead to increased mortgage payments, which might pose financial challenges for borrowers if they are not adequately prepared for the higher costs. There is also always the possibility that rates continue to increase or stay the same over the next few years, pushing the window for refinancing out further.
In a seller’s market, asking for seller concessions may also put a buyer at a disadvantage in having their offer accepted. A winning strategy is to offer over asking the amount of the temporary buydown and then requesting seller concessions of an equal amount. This ends up netting the seller the same profit in the end and softens the immediate blow of today’s high rates for buyers.
Consider Adding a Temporary Buydown to Your Next Offer
In the face of a high-rate environment, temporary rate buydowns are a financial respite for borrowers and a valuable tool for sellers and Realtors looking to increase demand in the face of high-interest rates. Don’t pass by a home you love, or need, now because of perceived unaffordability. There is always an affordable home-buying solution.
Cori Pugsley is a Mortgage Advisor with Movement Home Loans, a locally-owned and operated mortgage brokerage offering nationally-competitive rates, astute counseling and reliable closings. Contact her with questions or to apply for a loan.