The last 2 weeks have mostly uneventful from a market news standpoint, but rates…
With home prices and mortgage rates at 20 year highs, homebuyers are looking for anything that will lower their monthly payment. A temporary 2/1 Rate Buydown (and even a 3/2/1 buydown) is getting a lot of marketing hype all over the mortgage industry, but is it the right mortgage strategy for you? Watch my video below to learn more about this mortgage product:
What is a 2/1 temporary rate buydown?
This type of mortgage product is not a true adjustable-rate mortgage (ARM), but it functions much like one. Let’s say that your interest rate today is 7%. With a 2/1 buydown, your seller or builder pays a hefty sum up front for you in order to reduce that rate. The first year, your rate would be 5%. The second year, your rate would increase to 6%. The third year, you’d be back at the 7% starting rate. Your monthly payment would of course be based on the lower starting rate, but would increase each year as the payment resets back to normal.
How do you arrive at the buydown cost?
This is simply the difference in payment between the P&I for years 3 through 30 and year 1 added to the difference in P&I for years 3 through 30 and year 2. This dollar amount is divided by the loan amount to give you the buydown factor. You would save 2% in rate for 1 year, 1% in rate for year 2 and then revert to locked market rate for years 3 and beyond.
What are the pros and cons?
With this strategy, you can certainly save some big money during the buydown periods. The seller or builder of the property funds the buydown account, and those funds make the additional payments for the actual rate on the mortgage. If you know you won’t be in the home very long, this can be an excellent strategy. The left over funds from the buydown account can reduce the principal balance on the loan if you pay it off before the temporary rate reduction period is over. If you’re planning on an income increase in the next 2 years, this could also be a good reason to employ the strategy.
The danger with these type of mortgages is that it’s very easy to find other uses for that money you’re saving every month. You may decide to bump up that car payment, eat out a little more often, or even have children on the way. When it comes time for the interest rate and payment to adjust upwards, it could make your monthly budget a little uncomfortable. Also, the money the seller is giving you to fund the buydown is not free. That money comes in the form of a higher sales price since they fund it from their proceeds at closing.
Another issue to consider is that if rates do fall, a refinance transaction is not free. You must account for those estimated transaction fees in your breakeven calculations. Closing costs on a new mortgage can be at least $6,000 or more.
Are there any alternatives?
Another strategy that I recommend is a permanent buydown. This strategy would likely reduce your rate by 1 full interest rate point instead of 2, but it is for the entirety of the loan. This continues to save you money for all 30 years if you kept the loan that long. I also recommend exploring alternative hybrid adjustable rate mortgages. Capital City Home Loans offers 3 ARM programs with fixed rate periods of 5, 7, or 10 years. Lots of my clients have chosen the 10 year fixed rate because it is much more likely that rates will fall or you will sell your home in a 10 year period than it is in a 2 year period.
Temporary Buydown Option
Estimated Rate = 7.625%
2/1 Buydown cost = $4,790.76 or 2.4%
Year 1 rate = 5.625% (Payment $1,151.32)
Year 2 rate = 6.625% (Payment $1,280.63)
Year 3-30 rate = 7.625% (Payment $1,415.59)
Total life of loan payments = $504,818.43
Now, here is why I don’t typically like the temporary buydown option as the best options; it isn’t always best execution rate (fewer investors who buy these mortgages along with an additional pricing hit to the rate), and the benefits don’t typically extend beyond the first year. Let’s look at the same borrower applying the same buy down funds for a permanent buydown.
Permanent Buydown Options
Estimated Rate = 7.375%
Permanent buydown cost = $4,790.76 or 2.4% (Assuming builder wouldn’t care if Temporary or Permanent)
Year 1 – 30 rate = 6.5% (Payment $1,264.14)
Total life of loan payments = $455,088.98
AND you qualify at the permanent buydown rate versus having to qualify at max temporary rate.
Here’s a great calculator for these transactions: https://www.mtgprofessor.com/calculators/Calculator7d.html
In this kind of rate and housing environment, there are all kinds of marketing ploys and gimmicks to draw you towards the shiny object. Talk with a trusted and experienced mortgage consultant before you make a decision. Purchasing a home is one of the biggest financial transactions most people will ever make, so be wise and understand what you’re signing up for.