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As you're looking for opportunities to save money during this period of soaring mortgage interest rates, a mortgage buydown is one solution that can lower your monthly payment.
A mortgage buydown is when you pay more money upfront in exchange for a lower interest rate on your loan. Let's go over how a mortgage buydown works, as well as the advantages and disadvantages of buying points when purchasing a home or refinancing.
How Does a Mortgage Buydown Work?
A mortgage buydown is the process of buying discount points at closing to prepay mortgage interest. Purchasing points can be done when buying a home or refinancing your mortgage to reduce your rate and monthly payment.
Each discount point costs 1% of your loan amount; for example, purchasing one point on a $250,000 loan would cost you $2,500 upfront. However, how much your rate is reduced per point purchased depends on the lender, and the rate drop isn't necessarily 1:1. For example, buying one point might lower your interest rate by 0.50% or 0.375% rather than a full 1%.
Shopping around with several lenders can help you compare rates and buydown options. Depending on the type of mortgage buydown, your rate reduction could be temporary or permanent. Here are three types of buydown structures:
Permanent Rate Reduction
In this scenario, the interest rate discount extends over the life of your loan, giving you a lower monthly payment during the entire amortization schedule.
3-2-1 Buydown
A 3-2-1 buydown is a temporary reduction where you get an interest rate that starts low and increases incrementally for the first three years. In the first year, your interest rate is 3% lower, the second year it's 2% lower and the third year it's 1% lower.
From the fourth year onward, the interest rate bumps up to the standard rate. For example, if the standard rate on your loan is 7%, it would be 4% the first year, 5% the second year, 6% the third year and 7% the following years.
| 7% rate with a 3-2-1 Buydown | |||
|---|---|---|---|
| Year 1 | Year 2 | Year 3 | Year 4 to 30 |
| 4% | 5% | 6% | 7% |
With this type of buydown, all the extra money you pay upfront goes into an account. Each month, an amount equal to your interest rate reduction is deducted from that account and applied toward your payments. In the end, you will still pay the same for the mortgage as you would without the buydown.
2-1 Buydown
In the 2-1 buydown, your interest rate is reduced by 2% in the first year and 1% in the second year. Then the rate increases the third year and stays the same the rest of the loan term.
Similar to a 3-2-1 buydown, the funds collected at closing go into an escrow account that's deducted from each month. You ultimately still pay the full amount for the mortgage as you would if you hadn't paid into the account upfront.
Pros and Cons of a Mortgage Buydown
Not sure if a mortgage buydown is right for you? Below are the advantages and disadvantages of buying discount points:
Pros
- Reduces your monthly costs: A lower interest rate can lower your monthly mortgage payment, freeing up cash for you to use on other long-term expenses or financial goals. The type of buydown you choose will determine whether or not your lower costs are permanent or only temporary.
- Saves you money in the long run: A lower rate can help you save thousands of dollars over the course of a 30-year mortgage. For example, securing a rate of 6% instead of 7% on a $400,000 home loan could save you almost $95,000 in interest over 30 years. However, with temporary buydowns, you will still pay the same amount in the end as you would with a standard 30-year mortgage.
- Points may qualify for a tax deduction: Since buying points is prepaying mortgage interest, points purchased may be eligible for the home mortgage interest deduction.
Cons
- It's expensive: Saving up a down payment for a home can be hard enough, and coming up with even more money to buy points for a purchase could be challenging.
- It may not be cost-effective: If you have plans to own a home for just a few years, you may not see enough interest savings from buying discount points for it to make sense.
- The discount may not last forever: Depending on the structure of your mortgage buydown, the lower interest rate may only be temporary, and the higher mortgage payment at the end of the low-rate period could stretch your budget.
Is a Mortgage Buydown Worth It?
A mortgage buydown usually makes the most sense for people buying a forever home or house they plan to own for a long time. That's because, the longer you own the home, the more likely it will be that you'll see the full benefit of interest savings after buying discount points.
If you sell the home too soon, you might not get a chance to see the breakeven point where the money saved from the lower interest rate starts to surpass the cost of buying points upfront.
Let's say you purchase a new home with a loan amount of $400,000, and buying one point for $4,000 drops your interest rate permanently from 6.75% to 6.25%. Below is a breakdown of a monthly payment comparison.
| Estimated Monthly Payment | |||
|---|---|---|---|
| No points | One point | Change | |
| Interest rate | 6.75% | 6.25% | -0.50% |
| Monthly Payment | $2,903 | $2,771 | -$132 |
In this scenario, it would take about 30 months—or 2.5 years—for the $132 in monthly savings to add up to the $4,000 you paid for the discount point. If you're planning to stay in the home for more than two years, interest savings continue to accumulate. On the other hand, a mortgage buydown might not make sense if you need to relocate, downsize or upsize before the two-year mark because you would leave before recouping the cost.
The Bottom Line
Homebuyers looking for a reprieve from high interest rates could consider a mortgage buydown to cut the rate when making a purchase. However, if you don't have the funds to do a mortgage buydown, there are other ways to lower your rate. For example, taking steps to strengthen your credit score could help you qualify for better interest rates and lower payments.
A higher score can also give you more purchasing power, expanding your options as you search for a new place to call home. Using an Experian membership, you can check your credit score for free and see what's affecting your credit history to devise a credit-building action plan.