When mortgage rates are higher, you may start hearing the term “rate buydown” more often.
A seller might offer one as an incentive. A lender may discuss one as an option. Or you might hear that paying points could help you get a lower interest rate.
But here’s where it can get confusing: not all mortgage rate buydowns work the same way.
Some are temporary and reduce the amount of your payment for a limited period of time. Others permanently reduce the interest rate on your mortgage.
Understanding the difference can help you compare your options and, more importantly, understand what you’ll actually be paying.
A mortgage rate buydown is a financing strategy used to reduce either the interest rate on a mortgage or the amount of the borrower’s payment, depending on the type of buydown.
There are two main types you’ll commonly hear about:
Temporary buydowns reduce the portion of the monthly principal and interest payment the borrower is responsible for during a specific period at the beginning of the loan.
Permanent buydowns generally involve paying an upfront cost, often through discount points, in exchange for a lower mortgage interest rate.
The distinction matters because the two strategies work very differently.
With a temporary buydown, the mortgage’s actual note rate does not change.
Instead, funds are placed into a buydown account and used to subsidize a portion of the borrower’s principal and interest payment during the temporary buydown period. Once that period ends, the borrower is responsible for the full payment based on the note rate.
With a permanent rate buydown, an upfront cost is paid to obtain a lower note rate. That lower rate applies according to the terms of the mortgage rather than stepping back up after a temporary period.
Think of it this way:
Temporary buydown = temporary payment reduction.
Permanent buydown = lower note rate.
A 2-1 buydown is one of the most common temporary buydown structures.
The borrower’s principal and interest payment is calculated using a rate:
Year 1: 2 percentage points below the note rate
Year 2: 1 percentage point below the note rate
Year 3 and beyond: Full note rate
For example, if the mortgage has a 7% note rate, the borrower’s principal and interest payment during the first year would be calculated as though the rate were 5%. During the second year, it would be calculated as though the rate were 6%. Beginning in year three, the borrower would make the full principal and interest payment based on the 7% note rate.
The mortgage itself was still a 7% mortgage from the beginning. The funds in the temporary buydown account make up the difference during the first two years.
A 1-0 buydown works similarly but lasts for one year.
Year 1: The principal and interest payment is calculated using a rate 1 percentage point below the note rate.
Year 2 and beyond: The borrower makes the full principal and interest payment based on the note rate.
A 1-0 buydown can provide a lower borrower-paid principal and interest payment during the first year of homeownership without permanently changing the mortgage’s note rate.
A permanent buydown is different.
With a permanent buydown, discount points may be paid at closing in exchange for a lower mortgage interest rate.
One discount point generally equals 1% of the loan amount, but that does not mean one point automatically lowers the rate by one percentage point. The actual rate reduction available for a particular cost can vary.
Because there is an upfront cost, buyers should consider more than simply whether the resulting rate is lower.
One useful question is:
How long would it take for the monthly savings to recover the upfront cost of the buydown?
That can help you evaluate whether paying for a permanently lower rate makes sense for your particular situation.
That depends on the type of buydown, loan program and transaction.
With a temporary buydown, funds may come from permitted sources such as the seller, lender, borrower, employer or another eligible party, depending on applicable program requirements. Contribution limits and other guidelines may apply.
That’s one reason you may hear about temporary buydowns when sellers are offering concessions.
Instead of simply looking at the amount of a seller concession, buyers can talk with their mortgage professional about how those funds may be used and which option could be most useful for their situation.
This is an important distinction.
For fixed-rate conventional mortgages sold to Fannie Mae or Freddie Mac with a temporary buydown, the borrower qualifies using the payment based on the full note rate, not the temporarily reduced payment.
In other words, a temporary buydown isn’t intended to make an otherwise unaffordable mortgage affordable.
The buyer should understand and be prepared for the full payment once the temporary buydown ends.
What if rates improve and you decide to refinance before your temporary buydown is over? Or what if you sell the home?
There may still be money remaining in the temporary buydown account.
Typically, those unused funds are applied toward the outstanding loan balance when the mortgage is paid off, so the remaining money isn’t simply lost. The exact treatment of any unused funds depends on the terms of the buydown agreement and applicable loan requirements.
That’s why it’s important to review the specific agreement and understand what will happen to any remaining funds if you sell or refinance before the buydown period ends.
There isn’t one answer that works for every homebuyer.
Instead, consider questions such as:
Looking at the entire picture can help you decide whether a buydown fits your finances and your plans.
A mortgage rate buydown is a financing strategy that can reduce a borrower’s interest rate or the portion of the monthly payment they’re responsible for, depending on the type of buydown.
A temporary buydown, such as a 1-0 or 2-1, temporarily reduces the borrower’s principal and interest payment without permanently changing the mortgage’s note rate.
A permanent buydown generally involves paying an upfront cost to obtain a lower note rate.
Understanding which type you’re being offered—and what happens to your payment over time—is the important part.
A lower payment sounds great. A lower rate sounds great.
But how you get there matters.
Before deciding whether a mortgage rate buydown makes sense, look at the cost, the note rate, the initial payment, the future payment and how long you expect to keep the mortgage.
If you’re buying a home in Michigan, we can help you compare the numbers so that you understand your options and can make an informed decision based on your finances and goals.
