Did you know the average homebuyer could spend over $100,000 in interest over the life of their mortgage? Consider a mortgage buydown if you want to save on mortgage interest payments. With this option, you are essentially prepaying interest to buy mortgage points or discount points that can reduce interest costs throughout the loan. While that sounds like a great option, not all mortgage buydowns lead to long-term savings, and even the best options might not make sense for all homeowners. Read on to understand when a mortgage buydown makes sense for you.
Understanding Mortgage Buydown
The concept of a mortgage buydown, as the name implies, is that you "buy down" some percentage of the mortgage interest upfront. In that way, you'll save on interest in the long term. With a mortgage buydown, you can purchase mortgage points or discount points. You'll pay 1% of the total loan value upfront for an interest rate reduction.
How much each mortgage point is worth varies from lender to lender, although it's rarely 1:1. One point might lower your interest rate by 0.25%, 0.375%, or 0.5%.
In the case of a permanent rate reduction, the average mortgage point is usually worth a 0.25% reduction in interest rate over the life of the loan. That means that if you purchase four mortgage points, your permanent interest rate would be reduced by 1%.
That sounds small, but it's significant. Here's an example: Suppose the total mortgage value is $250,000. Each mortgage point costs $2,500 upfront. If you buy four mortgage points, it costs $10,000. If each point reduces your mortgage interest rate by 0.25%, you'll get an interest reduction of 1%. If the standard interest rate is 8%, and you can lock in 7% over 30 years on a $250,000 mortgage, you'll save over $61,000 in interest payments over the loan's lifetime. That's an average savings of around $1,700 per year in interest payments.
Types of Mortgage Buydown Structures
Mortgage buydown structures vary by lender and specific offerings. While permanent rate reductions make sense for anyone planning to live in a home for over a few years, the other options only make sense in certain cases. Here's how each one works.
Permanent Rate Reduction
In the case of a permanent rate reduction, you'll get the interest rate discount for the loan's entire term. That means you'll have lower monthly payments and save on interest throughout the loan's amortization schedule.
3-2-1 Buydown
A 3-2-1 buydown is the least common buydown structure. It only makes sense if you have additional savings and need to pay less monthly payments for the first few years you have the mortgage. With a 3-2-1 buydown, you'll get a temporary reduction in interest while it increases incrementally for the first three years.
The name 3-2-1 comes from the percentage of interest reduction. Your interest will be 3% lower than the final interest rate in year one. In year two, it will be 2% lower, and in year three, it will be 1% lower. From the fourth year, you'll pay the standard offered interest rate.
With this structure, you're directly paying interest upfront. The additional payment goes into an account used to make the mortgage difference each month. With this buydown structure, you won't save on interest, but you will have lower monthly mortgage payments for the first three years of the loan.
2-1 Buydown
Similar to a 3-2-1 buydown, a 2-1 buydown reduces mortgage interest rates for the first two years of the loan. Your interest rate will be reduced by 2% in the first year and 1% in the second year. By the third year, the interest rate will be the full agreed-upon interest rate and remain for the duration of the loan. With this structure, you won't save on interest, but you will have lower monthly mortgage payments for the first two years of the loan.
1-0 Buydown
The most common buydown structure is the 1-0 buydown, which works similarly to the longer options above. With the 1-0 buydown, you'll make an additional payment upfront in exchange for a 1% reduction in interest rate for the first year. With this buydown structure, you don't save on interest, but it will reduce monthly mortgage payments for the first year.
Advantages of Mortgage Buydown
A mortgage buydown has significant advantages, including:
- Lower monthly payments: During the buydown period, you'll reduce your monthly mortgage payments, potentially freeing up funds for other savings goals.
- Long-term interest savings: With a permanent mortgage buydown, you could save thousands of dollars in interest over the loan term.
- Tax savings: Buying mortgage points could help you take a home mortgage interest deduction. If you buy a home in a high-earning year, this can be an extra benefit.
- Lower sale price: In some cases, choosing a buydown may help you to negotiate a lower sale price on the property.
Disadvantages of Mortgage Buydown
While a mortgage buydown makes sense for many people, there are a few significant disadvantages to be aware of, including:
- No net savings: If you're not careful about the mortgage buydown terms, you might not save on interest while paying more upfront.
- Loss of value: If you're planning to move within a few years, the additional mortgage points savings might not be worth the upfront expense.
- Discounts are temporary: In the case of 3-2-1, 2-1 or 1-0 mortgage buydowns, the discounts are limited to a few years and don't lead to long-term interest savings.
- Better ways to invest: Suppose you pay $10,000 for a 3-2-1 mortgage buydown. While you'll have lower monthly mortgage payments for three years, there are no savings in the long term. You could invest that $10,000 and earn higher returns to help pay off the mortgage while building long-term wealth.
How to Qualify for a Mortgage Buydown
Mortgage qualification requirements vary from lender to lender. The basic financial strengths that can help you secure a mortgage will also help with buydown options. Consider reducing total debt, increasing income and working to build a good to excellent credit score to get the best mortgage terms.
You may only be eligible for a buydown when you purchase or refinance your primary or secondary residence. You can't use mortgage buydowns on investment properties. In addition, you usually must qualify for the standard interest rate on a zero-point loan to use a buydown home loan.
How to Get a Mortgage Buydown
To obtain a mortgage buydown, you will need to follow the same steps as any other mortgage loan. This includes providing the lender with documentation, including your government-issued ID, Social Security number and total income and debt information. The lender will also check your credit score.
To apply for a mortgage buydown, start by applying for a standard preapproval with multiple lenders and comparing rates. Consider which lenders offer a mortgage buydown and total interest rates and fees to choose the best option.
To apply for a mortgage buydown, you'll need to provide:
- Government-issued ID
- Social Security number
- Proof of income, such as W-2s or paystubs
- Proof of additional assets, savings or investment accounts
- Bank statements in some cases
- Information on total debt
Should You Use a Mortgage Buydown?
A mortgage buydown isn't the best choice for everyone. You need to consider how long you'll be in the home, whether the rate reduction is permanent or temporary and how much savings you have for closing costs plus a buydown. It can be a smart choice if you can afford a permanent rate reduction mortgage buydown and plan to stay in the home for at least five to six years.
Qualifying for a mortgage buydown follows the same steps as qualifying for other mortgage options, with a few limitations for certain loan types in some states. Ready to get started? Find the best mortgage lenders for first-time homebuyers who can walk you through a mortgage buydown and offer excellent rates!
Frequently Asked Questions
Are mortgage buydowns only available for certain types of loans?
Yes, some loans have limitations on mortgage buydowns. For example, you can’t use a mortgage buydown on an investment property or with a cash-out refinance. In addition, government-backed loans have guidelines and limitations about how you can use mortgage buydowns, and some states limit seller subsidies to prevent overly inflating h
How much does a mortgage buydown cost?
Mortgage buydown costs vary by the type of buydown. Each mortgage point costs 1% of the total mortgage amount for a permanent mortgage buydown.
Can a mortgage buydown be canceled or refunded?
No, generally, a mortgage buydown can’t be canceled or refunded. For most mortgage buydowns, the break-even point for mortgage interest savings is within four years of taking the mortgage. The only exception is a possible refund in temporary buydown mortgages if you pay off the mortgage before all the buydown funds have been applied.
About Alison Plaut
Alison Plaut is a personal finance and investing writer with a sustainable MBA, passionate about helping people learn more about wealth building and responsible debt for financial freedom. She has more than 17 years of writing experience, focused on real estate and mortgages, business, personal finance, and investing. Her work has been published in The Motley Fool, MoneyLion, and she regularly contributes to Benzinga.