Buydown: A Way To Reduce Interest Rates
Since buydowns are negotiated, they can be arranged in a variety of ways. The most common structures that lenders use are the 3-2-1 buydown and the 2-1 buydown. However, regardless of the structure, the principles are the same.
The buyer, seller or builder will pay the lender the difference between the standard interest rate and the lowered rate through points at closing. The buyer will benefit from the reduced interest rate until the buydown expires, usually after a few years. Once it does, the buyer will have to pay the standard interest rate for the remainder of the term, which will cause their monthly mortgage payments to increase.
3-2-1 Buydowns
A 3-2-1 buydown enables a buyer to pay less interest on their mortgage for 3 years after obtaining the loan. The points paid upfront reduce the interest rate by 1% for each of those first 3 years.
Let’s say a buyer wants to borrow $400,000 and qualifies for a 30-year fully amortized mortgage at an interest rate of 5%. The buyer decides they want to lower their interest rate for the first 3 years with a 3-2-1 buydown. In this scenario, the buyer would pay an interest rate of 2% the first year, 3% the second year and 4% the third year but would have to pay the full 5% from years 4 – 30.
Review the chart below to see how the buydown would affect the buyer’s monthly mortgage payments.
Year |
Interest Rate |
Monthly Payment |
Monthly Savings |
Annual Savings |
1 |
2% |
$1,478.48 |
$668.81 |
$8,025.70 |
2 |
3% |
$1,686.42 |
$460.87 |
$5,530.44 |
3 |
4% |
$1,909.66 |
$237.63 |
$2,851.50 |
4 – 30 |
5% |
$2,147.29 |
$0 |
$0 |
While the number of points charged for the buydown differs between lenders, the cost of the buydown is usually roughly equal to the amount the buyer would save in interest. In this case, the total cost of the buydown would be around $16,400.
2-1 Buydown
A 2-1 buydown also provides a buyer with a discounted interest rate but only for the first 2 years of the loan’s term. With this option, the interest rate would be 2% lower the first year and 1% lower the second.
Based on the previous example of a $400,000 30-year loan with a standard interest rate of 5%, the buyer would be expected to pay an interest rate of 3% the first year, 4% the second year and 5% from years 3 – 30.
Year |
Interest Rate |
Monthly Payment |
Monthly Savings |
Annual Savings |
1 |
3% |
$1,686.42 |
$460.87 |
$5,530.44 |
2 |
4% |
$1,909.66 |
$237.63 |
$2,851.50 |
3 – 30 |
5% |
$2,147.29 |
$0 |
$0 |
The buyer would save approximately $8,380 in interest, so the buyer should expect the total cost of the 2-1 buydown to be in that same ballpark.
Evenly Distributed Interest Rate Reductions
In some circumstances, a buyer may choose to purchase enough discount points to reduce their interest rate evenly over the life of the loan. By obtaining a buydown loan, the buyer pays an even larger sum upfront that prevents their interest rate and thus their monthly mortgage payments from ever increasing.
Using the same example as above, the buyer would be expected to pay a monthly mortgage payment of $2,147.29 for a zero-point loan, which is a loan without any discount points applied. If the buyer decides they’d rather buy down the mortgage and pay 4% interest throughout the loan’s term, their payments would look like this:
Year |
Interest Rate |
Monthly Payment |
Monthly Savings |
Annual Savings |
1 – 30 |
4% |
$1,909.66 |
$237.63 |
$2,851.50 |
Because the buyer would be lowering their interest payments for the entire life of the loan – instead of just 2 or 3 years – the total cost of the buydown would be significantly higher. It would cost the buyer somewhere around $85,550.