Buy Downs Revisited
A "buy down" is the payment of discount points to a lender in exchange for a reduced rate of interest on a loan. (A discount point is 1% of the loan amount). A reduced interest rate, not only affords buyers a lower payment, it also allows them to qualify at the lowered rate. Both buyers and sellers can buy the rate down. To a mortgage broker, discount points are the opposite of rebates: they're monies paid to the lender instead of being paid out by the lender.
TWO KINDS' PERMANENT AND TEMPORARY
There are two kinds of buy downs permanent and temporary. A permanent buy down is also known as a rate discount i.e., paying discount points to permanently reduce the rate of the mortgage. A permanent buy down is for the life of the loan. For example, a lender may offer a rate of 7% with no points or 6.375% with 2 points. Thus, the six and three-eighths percent in this example constitutes the discounted rate.
A temporary buy down is created when funds are placed in escrow outside the control of the borrower or the lender to offset the monthly payment required by the terms of the note. The funds in escrow reduce the effective payment rate but not the note rate. A temporary buydown may be for 1, 2, or 3 years. A buy down for 2 years is referred to as a 2-1 buy down and one for 3, is notated as a 3-2-1. To illustrate, a 2-1 buy down for a typical 30-year fixed rate mortgage at 7% with two points could carry an effective payment of 5% in year 1, 6% in year 2 and then revert to the note rate of 7% in year 3.
As previously mentioned, the buy down cost may be borne by the seller or the borrower. In some cases the buy down funds may be paid by the lender in what is know as a "lender subsidized" buy down where the note rate of the loan is increased to reduce the upfront cost of the subsidy. This is a "reverse" discount. The example above might be augmented to 5.5%-6.5%-7.5% with one point and no buy down cost.
HOW MUCH FOR HOW MUCH?
Whether they're permanent or temporary, buy downs are not cheap. The buy down rate of exchange for a permanent buy down is not 1:1. As a "general rule of thumb", one discount point will lower your fixed interest rate .25% or your adjustable rate .375%. For a temporary buy down the rate is likely to approximate 1 point in cost for 1% interest rate reduction.
WHY USE A BUYDOWN?
The primary reason for utilizing a buy down is to qualify for a larger loan. Obviously, if the borrower's monthly payment is lower, he can afford a larger mortgage. The temporary buydown can also offer a psychological benefit by allowing a borrower to ease into a higher housing expense. If a borrower is accustomed to paying $1,000 per month, but in order to purchase a desired home a larger mortgage is required, his monthly payment will be higher. A temporary buy down can offset the difference between the desired payment and the required payment.
A popular application of the temporary buy down utilized frequently among the home-building community is to advertise dramatic temporary interest rate buy downs as an enticement to purchase a new home. If interest rates are in the 6s & 7s, a buy down allows the borrower a potential fixed rate mortgage in the 3s or 4s.
TO BUY OR NOT TO BUY
Again, as a rule of thumb, it's probably not to one's benefit to buy the rate down if
* you*re not going to stay in your home more than 3-4 years
* you think you*ll refinance before then
On the other hand, it may be worthwhile considering
* if you have surplus funds to be utilized (owing to seller concessions)
* if you plan to stay in you home for more than 5 years
* if you plan to keep your property as an investment after you move
* or you don't plan on refinancing in the near future
BREAK EVEN ANALYSIS
The definitive way to see if a buy down is of benefit is to do a break even analysis. To do this, you simply divide the amount required to buy the rate down by the difference in payment between the interest rates being considered. This yields the number of months it would take to recoup your investment or to break even on your buy down.
Tax deductibility Is another factor to consider. For a home loan purchase the points paid can typically be considered tax deductible in the year they are paid; however, with a refinance loan, the points paid can only be deducted over the term of the loan.
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