What is an interest rate buy-down, and how do they work to help both home buyers and home sellers?
In short, it's when an interest rate is "bought down" from the current rate down to a lower interest rate, lowering the monthly mortgage payment for the buyer for a fixed time, and making the home more affordable. In some cases, it can make the difference between affording or not being able to afford the home payments.
How does it work?
In today's residential real estate market, a typical way this works is that the seller offers to pay for the buy-down cost on behalf of the buyer as a way (a) to avoid a large price cut in the sale price, or accepting a lower-priced offer, and (b) by making the payment more affordable for the buyer - a classic win-win scenario.
Sounds great, but tell me more
Here's an example of how this could work. Let's say a home is listed at $500,000 and interest rates are at 7%. The buyer is ready to put down 20% as a downpayment and considers getting a mortgage for $400,000. At 7%, the monthly principal and interest (P&I) payment would be $2,661.21. After adding in home owners insurance, an home owner's association fee, and utilities, the buyer discovers that their payment is unaffordable.
So, what does the buyer do? They like the home, but the housing payment - all in - is just too expensive at $500,000 and with a mortgage loan at 7%. If interest rates are not moving down that much, what buyers usually do is to consider offering a lower price on the home. To make a real difference in the monthly payment, the buyer would have to offer a much lower price, say $450,000 or $460,000. If the home is actually valued at $500,000 (for the sake of this example, let's say it is), such an offer would be considered by the seller to be very low, maybe even insulting.
An alternative approach would be to have the seller buy-down the buyer's interest rate. In a "2/1" buy-down scenario (there are many variations on this), the seller would pay the buyer's lender to lower the interest rate by 2 points for the first year, and by 1 point for the second year. In year 3, the interest rate returns to "par" (7% in this example), and with a 30-year mortgage, the remaining 28 years would be at 7%.
Year 1 - 5% interest rate
At 5%, with a full purchase price of $500,000, the P&I becomes $2,147.29 - a savings of $513.92 per month for the first 12 months (annual saving of $6,167.08 for the first year).
Year 2 - 6% interest rate
At 6%, the P&I becomes $2,398.20 - a savings of $263.01 per month for the second 12 months (annual savings of $3,156.09 for the second year).
Cost to the seller
Great, but who pays? The buyer can pay, but in this market, the seller usually offers to pay. How much does it cost? It depends on a few factors, but the cost might be as low as ~$10,000 (it depends on the lender, the loan amount, cost per point, etc.). So, the may seller pay only ~$10,000+/- at closing and nets $490,000 for the sale instead of accepting $450,000 or $460,000. And, if you were curious, assuming the seller accepted an offer of $450,000 - not likely in this environment - and the buyer secured a mortgage for $360,000 (80%) at 7%, the P&I payment would be $2,395.09, essentially the same as the year-2 payment.
Is it worth it? Maybe
You may observe that the payment would reset to 7% in year-3 with a buy-down with the monthly payment going back up to $2,661.21 in year 3, whereas with a straight purchase for $450,000 at 7%, the payment would remain fixed at $2,395.09 for years 3-30, meaning it might seem like it's not worth it after year 2. This would be true if there was no opportunity to refinance the loan in year 1, 2 or 3. There is definitely some calculating and forecasting that the buyer needs to do, and if it is likely that rates will come down, then the buyer can plan to refinance before the rate resets, and in the process, capture the savings for the first 2 years and then lock-in a lower rate by refinancing. Of course, foregoing the buy-down scenario ensures that the buyer does not enjoy the savings in year 1 or 2, and the buyer risks not getting the home in the first place if the seller chooses not to accept the $450,000 offer price.
The market environment when it makes sense
An interest rate buy-down scenario makes sense when home prices are not moving down and dynamics generally favor sellers who don't want to accept deep price cuts, when there is competition for a segment of homes at a certain price point, where multiple offers by buyers are possible, where the buyer is squeezed to make the home payments in the first couple of years, but early career income growth is likely (think, young professional, a business that is rapidly growing, etc.), and the buyer is comfortable assuming some risk regarding the refinancing.
Marry the home - date the rate
This old real estate cliche puts a fine point on this mortgage tool. The idea of "marry the home, date the rate" means if you find your dream home and really want to secure it, but the interest rates are not ideal, then you can choose to buy the home if you can comfortably afford the payment (the marriage) and then plan to refinance later when loan rates and terms are more desirable (dating the rate, e.g., it's not permanent).
More information
We are not lenders and everything in this post is meant for informational purposes only. If you are interested in learning more about this, ask your lender how it might work in your circumstances. Of course, we work with lenders who put together rate buy-downs for clients and can talk with you about whether and how it could work for you.
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Contact us with any questions or comments.
-Kevin and Diane
