A mortgage buy down gives the buyer of a home a rate that's lower than the current interest rate for two or three years, thus making the buyer's monthly payments lower and more affordable.
A mortgage buy down is an effective tool for home builders, home sellers and even home buyers.
For example, a home builder may be having a hard time selling his homes for whatever reason. He can approach the lenders he works with and offer to pay additional points on a mortgage to buy down the interest rates for buyers, which makes for an attractive offer.
The seller of a home may also offer the buyer a mortgage buy down in order to close the deal. The seller could lower his price, of course, but that wouldn't have as dramatic an effect on short term payments as a mortgage buy down would.
The buyer may be in a situation where the person (or a spouse) is returning to the job market, or has just graduated from college. In either case, money is tight at the moment, but the income is expected to increase over the next couple of years. It may be advantageous to buy down the mortgage so that monthly payments are lower until the income rises.
How does a mortgage buy down work?
There are two common types of mortgage buy downs. One is called a 3-2-1 buy down. In this case, the buyer pays an interest rate for the first year of the mortgage that's three points below market rate, then pays an interest rate that's two points lower in the second year, then one point lower in the third year. In the fourth year, the buyer is paying what the market rate was when he took out the mortgage in the first year.
The other type of mortgage buy down is called a 2-1 buy down. As you probably guessed, this means that the buyer pays an interest rate that's two points lower than market rate for the first year, then one point lower for the second year, and then in the third year pays the full market rate.
To illustrate how effective a mortgage buy down can be on monthly payments, let's use a 2-1 buy down on a mortgage amount of $150,000, and a market rate of 6%. If the buyer were paying the full 6%, his monthly principle and interest payment would be $899.
In the first year, the buyer's monthly principle and interest payment at 4% would be $716. That's a savings of $183 a month, or $2196 a year. In the second year, the buyer's interest rate increases to 5%, and his monthly princple and interest payments increase to $805. That's $94 a month less than what he would be paying at 6%, or $1128 for the entire year.
The buyer has saved $3324 over the course of two years. The home builder or seller could have reduced the price of the home by that amount and stuck with the 6% interest rate, but the buyer would only have saved $20 a month in the first year versus $183.
Obviously, the mortgage buy down offer is a strong incentive to buy.
The incentive becomes even stronger with more expensive homes.
Let's use a mortgage amount of $350,000 and a market rate of 6.75% as an example.
If the buyer paid the full 6.75%, his monthly principle and interest payments would be $2270.
With a 3-2-1 buy down, the buyer's monthly principle and interest payments would be $1621 per month at 3.75% for the first year. That's a savings of $649 a month, or $7790 for the entire year.
In the second year, the buyer is paying 4.75%, and his monthly payments are $1826. That's a savings of $444 a month, or $6332 for the entire year.
In the third year, the buyer's rate is 5.75%, and his monthly payments are $2043 a month, a savings of $227, or $2724 for the year.
Rather than reduce the price of the home by $16,853, the home builder or seller has given the buyer a very strong incentive to close the deal.
The home builder already has a working relationship with lenders, and so can arrange for mortgage buy downs easily. For a private seller, or for the buyer, making mortgage buy down arrangements with the lender will require some consultation with the lender in advance.
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