Mortgage buydowns are nothing new, but have recently been making a big comeback with interest rates in 2022 into 2023. You may or may not have heard of them before, but you’ll definitely want to be familiar with the pros and cons of using a mortgage buydown before purchasing your next home.
History of Mortgage Buydowns
With homebuyers searching for ways to lower their mortgage rates, a previously popular home-selling strategy is making a comeback. Known as a temporary buydown and commonly referred to as 3-2-1 or 2-1 loans, this tactic was frequently used during the late 1970s and early 1980s when mortgage rates were as high as a staggering 18%.
The resurgence of temporary buydowns is well-timed as mortgage rates are currently at a 20-year high and the Federal Reserve is expected to raise them even further this year in their attempts to regain control of inflation. As a result, fewer people are able to afford to buy homes. In some markets, the power dynamics have shifted, with buyers holding more negotiating power than sellers.
In this environment, where interest rates are increasing and sellers must work harder to attract buyers, temporary buydowns can be an effective tool. However, buyers need to be aware of both the positives and negatives of exactly what 3-2-1 & 2-1 loans mean for the immediate and future of their monthly payments.
PRO: What it is & How it Saves You Money
A temporary buydown allows the homebuyer to make lower monthly payments for the first year, second and sometimes third year, rather than paying their full mortgage payments from the start. This is achieved by offering discounted payments by purchasing percentage points off of the original interest rate. As an example, a 3-2-1 buydown lowers the interest rate by 3% in the first year, 2% in the second year, and 1% in the final year of the three-year period. Meanwhile, a 2-1 buydown decreases the interest rate by 2% in the initial year and then by 1% in the following year before returning to its original rate.
To put this in a real world scenario, the average home sales price in Metro Detroit is $300,000. If a buyer put 10% down, they would still need to finance $270,000, which at the current interest rate of 6.5% comes out to roughly $2,180 (subject to taxes & insurance). If they obtained a mortgage for $270,000 using a 3-2-1 buydown, their monthly principal and interest payments for the first year at a 3.5% interest rate would be $1,692, a savings of $488 per month. The second year their monthly payment would be based off of a 4.5% interest rate, increasing to $1,848 per month, then a 5.5% rate for the third year making the payment $2,013. After the first three years, the interest rate would return to 6.5% with a monthly payment of $2,180 for the remaining 27 years of the loan. By utilizing this particular buydown, the borrower would save approximately $11,844 over the first three years of their loan. Sounds amazing, right? Surely there has to be a catch.
CON 1: Upfront Cost
In a perfect world, money would be free. Of course this isn’t the case here. The truth is that someone has to pay that $11,844 up front at the start of the loan to provide the discounted rate. Traditionally, temporary buydowns are covered by home builders and sellers as a closing cost that is equal to the interest savings of the buyer, which is deposited in that amount into a custodial account at the closing of the sale. The loan servicer then uses the funds from the account to make up the difference between the full loan payment and the discounted payment that the homeowner is making each month.
The problem here is that there is no guarantee that a home builder or seller will be willing to agree to covering this cost. Also, in many cases we have been able to negotiate a similar amount off of the price of a home, saving our buyers a lot of money in the process - just not all up front.
CON 2: Not a Permanent Solution
While the savings from a 3-2-1 buydown over the first three years are fantastic, it is important to keep in mind that it is NOT a permanent solution to being able to own a home. Once the initial discounted period ends your monthly payment will return to the full amount determined by the interest rate at the time of signing the contract for your mortgage.
An alternative solution to this is instead of using a 3-2-1 loan, ask how much it would cost to PERMANENTLY buy down your interest rate. At the time of this article being written with the current rate of 6.5%, a buyer could buy down their rate to 5.5% for roughly $10,000. To break even on this investment a homeowner would have to live in their home for a minimum of 5.3 years, but the overall savings over the life of a 30 year fixed mortgage will GREATLY exceed those of a 3-2-1 buydown.
To use some actual numbers and how much of a difference 1% in interest can make, try this easy to use MORTGAGE CALCULATOR.
CON 3: Consumer Behavior
Another downside to the 3-2-1 buydown is people tend to get comfortable with the lifestyle they create. Now, this isn’t to be taken as a shot towards how people live, but we as humans are creatures of habit - and we aren’t always the most responsible about how we spend “extra” money. For many people, if they are able to save $500 a month for an entire year, by the end of that first year a lot of that money will have been put towards non-essentials like dining, shopping, or maybe even a new vehicle rather than into a 401K, savings account or investing it wisely. The problem with this is pretty easy to see coming. That “extra” money becomes less the second year, then even less the third year before it is no longer “extra,” it is REQUIRED in order to stay current on mortgage payments. Having to readjust your lifestyle to fit your budget (or even worse, using credit cards to keep your lifestyle) can be difficult and for those who fail to do so, it could cost them their new home.
Now, you can argue that with wage growth taken into consideration that your annual take-home will grow to cover the difference, but there is no guarantee of this happening, while the monthly payment of 3-2-1 buydown is in fact, GUARANTEED.
Two possibly better options would be to look into purchasing a home that already fits what you are able to afford as a monthly payment, or again to look into permanently buying down your interest rate. A rule of thumb for purchasing power versus interest rates is that for every 1% that interest rates go up a buyer loses 10% of their purchase power. So if the full monthly payment on purchasing a home for $300,000 is a little out of reach, it may benefit you to look more at homes in the $270,000 price range. Of course you can always submit an offer below a home’s asking price - the worst anyone can say is “no”. Homeownership should be a wealth-building, memory making, tax-savings vehicle and the last thing anyone should do is to purchase beyond their means to where they are being stretched too thin financially every month.
CON 4: There Are No Guarantees on Interest Rates
Just as there are no guarantees in life, there are no guarantees on where interest rates will go in the future. Yes, it is quite possible that for someone using a 3-2-1 or even a 2-1 mortgage buydown that by the time their discounted rate ends interest rates will have come back down to where refinancing the home at a better rate would help keep payments low. Even though we do predict that by sometime in 2024 interest rates will come back down to 4.5% to 5%, we can’t make the promise that they will, or when.
With all of this being said, are we suggesting that 3-2-1 and 2-1 loans should not be considered as an option? Not at all. Every home purchase is different and everyone has different needs in a home. The best and safest bet is to discuss ALL of your options with your lender to decide which works best for you and your family in the long run.
If you are looking to make a move anytime in the future, give us a call at 248-484-4698. We would love the opportunity to show you why The Perna Team is the team of choice in Southeast Michigan and how we help hundreds of other families with their real estate needs every year. If you are looking for a fantastic lender to help get you pre-qualified for your home purchase, we also have an in house lender that we would be happy to connect you with.
Posted by Michael Perna on