A temporary buydown refers to an arrangement between borrower and lender whereby the former would make a cash deposit upfront, while the latter reduces mortgage payment in the early years of the loan.
The cash deposit will be kept in an escrow account which will be used to offset the monthly installments, resulting in the lower payment amounts.
During the period when the buydown is active, the payment made to the lender will be made up of a portion from the borrower and a portion from the escrow account.
This is how the payments made by the borrower becomes lower.
People often wonder how temporary buydowns make any logical sense at all since the money paid upfront would eventually be used to pay for the home loan, and that payments will rise back up to a normalized level after the early years of the loan.
The answer is simple. It’s for qualification.
As the monthly payment amount plays an important role during underwriting in the determination of the final loan amount a borrower qualifies for, reducing the payments the loan starts off with reduces the debt obligation figure used during qualification.
This enables the borrower to obtain a higher loan amount than if he were to apply for a regular mortgage without any buydowns.
Home sellers who are desperate to let go of their properties are well-known to contribute to the cash deposit requirements in an effort to help buyers obtain sufficient financing to complete the purchase.
Temporary buydowns are options that feature more commonly on fixed rate mortgages.
The 3 most popular programs are:
- 3-2-1
- 2-1
- 1-0
A 3-2-1 buydown means that the rate will be 3%, 2% and 1% lower than the loan rate in the years 1, 2 and 3 respectively.
A 2-1 refers to a reduction of 2% followed by 1% on the loan rate on the first and second year of the loan respectively.
A 1-0 describes just 1% reduction in the loan rate only in the first year.
As can be observed above, the 3-2-1 buydown will result in the biggest drop in early year payments. Meaning that it will allow a borrower to obtain the largest approval possible.
Permanent buydown
If there is a temporary buydown, then there must also be a permanent buydown?
The essence of such loan arrangements is that they only result in lower payments in the early years. Thus the word temporary.
If lower payments last for the life of the loan, making it permanent, there are already other types of features available in the industry that serves this purpose.
In this way, points can be seen as a permanent buydown.
Borrowers essentially pay extra points upfront in exchange for a lower interest rate, resulting in a permanently lesser monthly payment.
By the same line of thought, making a larger down payment can also be seen as a form of permanent buydown as it permanently reduces the monthly liability even at the same interest rate.