Temporary Buydown: What You Need to Know
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Originally Posted On: https://chlending.com/blog/f/temporary-buydown-what-you-need-to-know
Temporary Buydown
When it comes to home mortgages, you need to understand how a temporary buydown works.
In 2022, mortgage rates more than doubled over the previous year. At their peak, interest rates rose to around 7.12 percent.
To help offset higher mortgage rates, many consumers use a temporary buydown.
Would you benefit from this type of mortgage transaction? Let’s dig in and explore everything you need to know about buydowns and how a temporary buydown can be a great choice for you.
Temporary Buydown 101
A temporary buydown is one of several mortgage financing programs available to homebuyers. It allows a borrower to reduce the interest rate on their mortgage. The interest rate reduction usually lasts for one to three years.
The most common type of temporary buydown is a 2-1 buydown.
This means the lender reduces the interest rate by 2% in the first year and 1% in the second year. After that, the interest rate reverts to the original rate for the rest of the loan term.
Other types of buydowns may have different reduction percentages, periods, or payment structures.
Before participating in any type of mortgage buydown, it’s critical to consider the costs and benefits of a temporary buydown and to compare it to other mortgage options.
How Does a Temporary Buydown Work?
Borrowers considering this type of mortgage option will work closely with their lenders. Here’s an overview of the process lenders and borrowers follow to put a temporary buydown in place:
- Borrower determines their desired payment
- Lender calculates the interest rate
- Lender lowers the interest rate
- Borrower pays upfront fees
At the end of the temporary buydown period, the interest rate on the loan reverts to its original level, increasing the borrower’s monthly payments accordingly.
The borrower, seller, builder, or lender may fund the temporary buydown. Lenders often use buydowns as a concession to help the borrower qualify for the loan or to make the mortgage more attractive.
A Real Life Example
In this example of how a temporary buydown works, the borrower would like to keep their monthly mortgage payments at $1,500 for the first three years of a 30-year mortgage. The buydown plan offered by the lender lowers the interest rate by 1% for the first three years of the loan.
How does the borrower make up for the lower interest rate?
At closing, the borrower will pay $5,000 – or two points. After the three-year buydown period ends, the interest rate on the loan will increase to its original level. As mentioned above, the borrower’s monthly payments also increase.
Benefits of a Temporary Buydown
A temporary buydown is an attractive option for borrowers who want to keep their initial monthly payments low, but who expect their income to increase in the future. There are several other benefits, including:
Qualify for a Larger Loan
A temporary buydown can help a borrower qualify for a larger loan. The lower monthly payments may help them meet the lender’s debt-to-income ratio requirements.
Cash Flow Flexibility
The lower payments during the buydown period can free up the borrower’s cash flow. This allows them to put more money towards other expenses or savings.
Easier Budgeting
Qualifying for a mortgage is the first hurdle for many borrowers. Budgeting for mortgage payments and other expenses associated with home ownership is another challenge.
With a fixed payment amount during the buydown period, the borrower can more easily budget for their monthly housing costs.
Tax Benefits
Depending on the borrower’s situation, they may deduct the upfront buydown costs on their tax return as mortgage interest, which can reduce their taxable income.
Borrowers should carefully consider their financial situation and goals and consult with a financial advisor or mortgage professional to determine if a temporary buydown makes sense for them.
Is a Temporary Buydown Right for You
There are several reasons you might consider a temporary buydown as a financing option for a mortgage loan.
As a borrower, you’ll find the lower initial loan payments, easier budgeting, flexibility, and tax benefits attractive. If you’re an investor, you can also benefit from a buydown.
Maybe you’ve come across an investment opportunity that offers a higher rate of return than what you’ll pay to fund the buydown. In that case, an investor might consider using their savings from the lower mortgage payment to fund the investment.
Whether you’re a traditional borrower or an investor, a temporary buydown may allow you to keep more cash reserves on hand. This can be helpful in case of emergencies or unexpected expenses.
A trusted mortgage broker can point you in the right direction regarding buydowns and other types of loan programs.
How to Execute a Temporary Buydown
We briefly talked about how a buydown works earlier in this article. Now, let’s look more closely at the steps taken to execute a temporary buydown.
Determine the Buydown Amount
The first step in executing a temporary buydown is to determine the amount of the buydown.
This amount is the lump sum payment made by the borrower to the lender, which reduces the interest rate on the mortgage loan. The buydown amount can vary depending on the lender and the terms of the loan.
Calculate the New Interest Rate
After determining the buydown amount, the lender will calculate the new interest rate based on the reduced principal balance. Earlier, you learned about the 2-1 buydown.
Another type of buydown – the 3-2-1 temporary buydown – lowers the interest rate by 3% during the first year of the loan. During years 2 and 3, the interest rate lowers by 2% in year two and 1% in year three.
Prepare the Loan Documents
After determining the buydown amount and new interest rate, the lender will prepare the loan documents for the borrower to sign. The loan documents specify the terms of the transaction, including the amount of the buydown, the new interest rate, and the duration of the buydown period.
Fund the Buydown
After signing the loan documents, the borrower will need to fund the buydown amount. The lender will specify how they want the funds, but most borrowers either send the amount through a wire transfer or a certified check.
Monitor the Buydown Period
The lender will monitor things during the buydown period to ensure that the borrower is making the correct payments. Savvy buyers should also keep track during this time so that they’re not caught off-guard when the monthly payment changes.
Revert to the Original Interest Rate
At the end of the buydown period, the interest rate reverts to the original rate. Naturally, the monthly payment also increases to reflect the higher interest rate.
Differences Between Traditional and Temporary Buydowns
Mortgage buydowns allow borrowers the benefit of lower interest rates for a set period. Some buydowns last for the first two to three years of the loan. Others last for the duration of the loan.
The fundamental difference between a traditional mortgage buydown and a temporary mortgage buydown is the duration of the reduced interest rate and lower payments.
A traditional mortgage buydown also involves paying additional fees as a lump-sum payment at closing. In exchange, the buyer gets a lower interest rate for the loan’s duration.
A temporary mortgage buydown involves a similar lump-sum payment at closing, but the reduction is only for a short period, such as the first few years of the loan.
In summary, a traditional mortgage buydown involves a lump-sum payment to qualify for a lower interest rate – usually for the full loan period. A temporary mortgage buydown involves a similar payment for a short-term reduction in interest rates and payments.
Why Sellers Like Temporary Buydowns
Homebuyers, particularly first-time buyers, often need a bit of incentive to commit to buying a specific home. Motivated sellers sometimes offer a buydown as an option.
It’s a win-win situation.
The seller gives prospective buyers an incentive to buy their property, without having to drop the asking price. For a hesitant buyer, a buydown may get them to the offer stage when they weren’t feeling entirely ready to buy.
For example, let’s say the buyer and seller are $5,000 apart despite the good negotiating skills of both parties. A temporary buydown removes the obstacle.
From a more humorous perspective, this financing option can also help the seller save face. No one wants to admit they sold their home at a significant price cut.
If the seller pays for a 2-1 buydown, the buyer saves a nice amount over the first two years of the loan. The amount comes out of the seller’s proceeds from the sale, and while it’s equivalent to a price cut, it’s not public knowledge.
You read earlier that just about any interested party can fund a temporary buydown. However, some mortgage companies make it a requirement that only the seller, builder, or lender can cover funding.
How to Negotiate a Buydown
Most homebuyers talk about loan options during the initial home loan application process, so it’s a good time to talk about buydowns too. Negotiating for a temporary buydown involves convincing the lender to lower the interest rate on your mortgage for a short period. Here are some steps to follow to negotiate a temporary buydown:
Understand the Terms
Before negotiating, make sure you understand the terms of your loan and the buydown option you’re interested in. You should also research current interest rates and typical buydown terms.
Present Your Case
Approach the lender with a clear proposal that outlines your request for a temporary buydown. Explain your financial situation. Talk about why you’re seeking a lower interest rate.
Provide Supporting Documentation
Provide any relevant documentation that supports your request, such as proof of income or employment, credit reports, or bank statements.
Offer Incentives
To sweeten the deal, consider offering incentives such as a larger down payment or a higher credit score.
Be Prepared to Negotiate
The lender may counter with their own terms or offer a different solution. Be prepared to negotiate to find a solution that works for both parties.
Get Everything in Writing
If you reach an agreement, make sure to get all the terms in writing and carefully review the contract before signing.
Buyers can also negotiate a temporary buydown with the seller as part of the home purchase agreement. In that case, it’s best to rely on the negotiation skills of your real estate agent.
Know Before You Sign
If you’re considering a temporary buydown, make sure you carefully evaluate the costs and benefits of the arrangement. While a lower monthly payment in the early years of the loan can help with cash flow, it may not be worth the cost of the buydown.
If you plan to sell the property, or refinance the loan before the buydown period ends, this might not be the ideal solution.
A financial advisor or mortgage professional can help you determine whether a temporary buydown is the best option for your particular needs and circumstances.
If you are a seller it’s vital to work with your real estate agent and/or a mortgage professional to understand the costs and potential benefits of this type of arrangement. You may also want to consult a tax professional to ensure that any payments made toward the buydown are structured in a way that maximizes tax benefits.
All parties involved in this type of transaction must also understand the tax benefits associated with home ownership and financing.
Need Help Financing Your Next Home?
For many homebuyers, paying a lump sum to their lender in exchange for a lower interest rate can make or break their ability to fund their home purchase.
A temporary buydown is an excellent financing strategy. Buyers, sellers, and lenders can work together to make homeownership a reality.
Even so, executing a temporary buydown requires careful planning and coordination between the borrower and lender.
At Competitive Home Lending, we’re here to help simplify the home financing process. Apply for a home loan with us and we’ll connect you with a local mortgage loan officer who can explain your financing options.