As interest rates have risen, temporary buydowns have become an option that some sellers and buyers may consider. A 2-1 buydown is a concession that can be negotiated with sellers to incentivize buyers. A 2-1 buydown essentially allows borrowers to make a lower mortgage payment for the first two years of their loan, and payments go back up on the third year of the loan but is a fixed rate mortgage.
If you’ve been considering purchasing a home but with rising rates you have reconsidered a 2-1 buydown may be the program that will allow you to buy now. We’ll explore exactly what a 2-1 buydown is, how it works, and the pros and cons to help you decide if this program is right for you.
What is a 2-1 Buydown?
A 2-1 buydown program is a type of mortgage where you reduce your interest rates for the first two years of a mortgage. If you opt for a 2-1 buydown, that means as a buyer, your interest rate is reduced by 2% the first year and 1% the second year.
In the third year, the interest rate goes to the original interest rate on the loan.
How does a Temporary Buydown Work?
A temporary buydown is a concession from sellers or builders available for primary home purchases. It allows borrowers to have a lower interest rate for the first two years of purchase and ease into their mortgage payments.
It will need to be included as an agreement in the purchase contract, and the real estate agent negotiates it during the offer process. The prepaid buydown is paid during closing into the escrow account. That amount is held in an escrow account and is applied to the buyer’s payment. The buyer will have a reduced monthly payment, and the difference in interest rates comes out of the escrow account. The first year, the interest rate is lowered by 2 percentage points and 1 percentage point the following year.
Temporary Buydown Scenario
Let’s look at a 2-1 buydown scenario* to help you understand just how this program could benefit you.
Let’s say you’re buying a $500,000 house with a 20% down payment and a mortgage loan of $400,000 and an interest rate of 6.99% and APR of 7.23%. A monthly principal and interest (P&I) payment would be about $2,658.52.
With a 2-1 buydown, your interest rate would decrease by 2% from the original rate for the first year. So, with a 4.99% interest rate, your monthly P&I amount would be $2,144.84.
The following year, your interest rate would be lower by one percentage point from the original rate, taking it to 5.99%. The monthly P&I amount you’d be paying would be $2,395.63.
Your payment would then be at the original 6.99% interest rate from the third year onwards, taking your monthly P&I back to $2,658.52.
Keep in mind that this scenario doesn’t factor in taxes and insurance, so your actual monthly payment amount will be higher than quoted if you escrow those and if you don’t those expenses will be in addition to your monthly payment. You can see the difference between years 1 and 2 versus year 3 and after. Keeping in mind what you’ll be paying for the first 2 years versus the third year onwards may allow you to consider buying now.
Pros and Cons of a Temporary Buydown?
The main thing to point out with a temporary buydown is just that, it’s temporary. While you are qualified in underwriting to be able to afford the payment based on the Full Interest rate, it’s important that you can make sure that payment fits in your budget.
A temporary buydown can benefit both sellers and buyers, it is more likely to occur in a buyers’ market where there are more properties available but not enough buyers. For buyers, this is a way to combat a market with high rates and allows them an opportunity to buy now, when interest rates are high. If rates go down, the buyer can refi later. If they don’t go down and continue to go up, then at least you’ve locked in a lower rate now. For sellers, it enables them to move properties potentially without having to reduce price while giving the buyer an incentive to buy now. For buyers, the reduced monthly payments in years one and two can help manage initial housing expenses.
Better to do a Temporary Buydown or an Adjustable-Rate Mortgage (ARM)?
There are some crucial differences between a temporary buydown and Adjustable-Rate Mortgage (ARM). With a temporary buydown, it’s temporary. You’ll lower the interest rate for the first two years but you’ll be in a fixed rate mortgage.
With an ARM your interest rate is set for a specific period but then adjusts, usually, annually thereafter. An ARM can be difficult to plan for in budgets due to not being able to know what the payment may be in the future.
The decision to do an ARM vs a Temporary buydown will be up to each individual persons scenario and what they feel comfortable with.
*The sample rates provided are for illustration purposes only. River City Mortgage cannot predict where rates will be in the future. Rate(s), APR(s) and payment info is valid as of 10/19/2022 and assumes 20% down Conventional Mortgage with 740 FICO score, 45-day rate lock, based on a single-family home with a DTI of 20%. All terms are subject to change without notice. Loans are subject to underwriting guidelines, and this is not a commitment to lend. 2-1 Buydown is available for conventional, FHA, and VA.