Temporary Buydowns Defined
What is a temporary buydown and do you want one? We’ve mentioned here on several occasions about how the mortgage industry seems to think up different lending terms on a regular basis but that’s really not the case at all. Yet in this instance a temporary buydown isn’t promoted as often as perhaps it should be as most mortgage lenders don’t even advertise the product. In the proper situation, temporary buydowns can help someone qualify for a mortgage at the outset while preparing for the future at the same time.
What is a temporary buydown?
Temporary Buydowns: Temporary vs. Permanent
A temporary buydown is exactly what it means. It’s a buydown but only for a predetermined period of time. In the mortgage industry, there are two types of buydowns, a permanent buydown and a temporary. A permanent buydown is a way to lower the interest rate on a mortgage and the rate remains at the initial level throughout the life of the loan.
For example, let’s say a couple is considering a 30 year fixed rate loan of $300,000 and the loan officer is quoting a rate of 4.25% with no discount points. If you recall, a discount point is expressed as a percentage of the loan amount and is a form of prepaid interest to the lender. One point is one percent of the loan amount. On a $300,000 mortgage, one point is $3,000 in prepaid interest. It’s also called a discount point because the rate is lowered because the couple paid $3,000 in points upfront.
The lender has no preference one way or the other if a borrower chooses to pay points or not as the lender gets the interest either way. If the 30 year fixed rate was 4.25% with no points the borrower could pay one point and lower the rate to 4.00% where it remains throughout the life of the loan.
In this example, the principal and interest payment was reduced to $1,432 from $1,475 for a monthly savings of $43 as a result of paying a point. Lenders offer a range of interest rates on the same loan program based upon the number of points paid. A permanent buydown is available for any fixed rate program of any term ranging from 10 to 30 years as well as for hybrid loans where paying points lowers the initial start rate and lifetime cap.
A temporary buydown is referred to as a “2-1” or “3-2-1” buydown and takes a little math to figure out. The lender can offer a temporary buydown on most any fixed rate program by calculating the interest over the initial period.
A 2-1 buydown means the interest rate starts out 2% lower than the permanent rate for the first year, 1% for the second then resting at the final note rate for the remaining term.
A 3-2-1 buydown works in the very same fashion yet starts out 2% below the final rate, and so on. A 2-1 temporary buydown for example might be 3.50% for year 1 then 4.50% for year two and 5.50% for years three and beyond. The way it is calculated is providing the lender the difference in interest from year one to year two by adjusting the final rate.
For example, a couple is interested in a 2-1 buydown because they expect in a couple of years they will have their student loans paid off and will more comfortably afford the monthly payment but for now they’d like to take advantage of the lower rate.
With a 30 year fixed rate of 3.50% on $300,000 the principal and interest payment is $1,347 and at 4.50% the payment is $1,520. 5.50% the principal and interest payment is $1,703. Remember, this is a temporary buydown and the lender is still owed the difference between the final rate and years one and two. This difference is $4,890 in interest. The borrowers can pay all or part of this upfront to the lender or allow the lender to adjust the overall note rate to accommodate the deferred interest. In this example, that equates to about 1.625% either in points at closing or adjusting the rate a bit higher.
There are a couple of reasons why a temporary buydown might be a good option. The first is simply to help qualify. Lenders can qualify a borrower based upon the initial rate and not the final one. That helps qualifying for a larger loan amount but should be examined in light of future income and expenses. If a borrower qualifies at say 5.50% now and takes out a 2-1 buydown and starts at 3.50% it helps monthly cash flow but if the borrowers do not qualify at 5.50% a lender will probably have to provide another option.
Temporary buydowns aren’t as common as they used to be primarily because interest rates overall have been near historic lows for some time although many anticipate rates to continue their upward path throughout 2017 and beyond as the economy continues to improve. If y you’re looking at a fixed rate to finance your next purchase ask your loan officer to calculate a temporary buydown for you to see if the extra cash flow each month makes sense in your situation.