When first-time buyers Rachel Shatto and Randy Nelson purchased a home in Oakland in May, they negotiated an interest rate buydown that effectively lowered their mortgage rate, and thus their monthly payment, for the first two years.
Although the seller made a lump-sum payment for the short-term rate decrease at closing, they increased their purchase price to compensate for it. This temporary rate buydown left them with more cash to pay for repairs and improvements the first couple of years, Shatto said.
Both temporary buydowns, which effectively lower the rate for one to three years, and permanent ones, which reduce it for the life of the loan, have become more popular since interest rates started soaring last year.
In June, 2.8% of 30-year fixed-rate loans funded by Freddie Mac had temporary buydowns, up from near zero a year ago but down from a peak of 7.6% in December 2022, shortly after rates spiked above 7% for the first time in more than two decades. After dipping as low as 6.14% in February, they surged above 7% again in August and now stand at 7.18%.
Renderings are seen on a fence for future green space and waterway at Landsea Homes at Alameda Marina.
Lea Suzuki/The ChronicleBuydowns are most common on new homes. When rates rise, builders frequently offer temporary or permanent buydowns as one of several incentives buyers can choose from.
A survey of builders in August asked what has been the most effective way to get buyers off the sidelines. The No. 1 answer, cited by 69% of respondents, was mortgage-rate buydowns, said Ali Wolf, chief economist with Zonda, a new-home data and consulting firm that did the survey. Only 22% said price cuts.
“When they lower prices, buyers already under contract at a higher price tend to cancel their contracts and it becomes a vicious cycle,” Wolf said.
Landsea Homes is offering buydowns on select homes in select communities including the newly opened Alameda Marina. “We are only able to offer them on homes that we can deliver within 30 to 60 days,” said Josh Santos, Landsea’s Northern California division president. “I’d say 75% of our buyers in the last 60 days” chose buydowns in lieu of other incentives such as options, upgrades or homeowners association dues.
A option for certain incentives, including interest rate buydowns, is seen on a screen at a sales office in a model home at Landsea Homes at Alameda Marina.
Lea Suzuki/The ChronicleSome sellers are also offering them on existing homes that have been sitting for a while.
Whether they make sense for buyers depends on myriad factors including their overall finances, the cost versus savings, how long they plan to stay in the home, whether they spend or invest their monthly savings, who’s actually paying for them, and future interest rates, the last of which is unknowable.
Borrowers should make sure they understand how buydowns work, the potential pitfalls and other ways to save money on a mortgage.
How permanent buydowns work
A permanent rate buydown is fairly straightforward. The buyer pays fees, called discount points, to reduce the interest rate — and therefore the monthly payment — forever.
One discount point equals 1% of the loan amount. To lower the note rate by 1 percentage point, a buyer today might pay around three points to four points. This cost can vary widely depending on the day, the lender and other factors, said Westin Miller, branch manager with Pinnacle Home Loans in Santa Rosa.
To figure out how long it would take for your monthly savings to equal the points paid, divide the total upfront fee by your monthly mortgage payment (or plug the numbers into an online mortgage discount points calculator).
Suppose a buyer can permanently lower the rate on a $700,000 mortgage to 6.5% from 7.5% by paying three points, or $21,000. That would lower the monthly payment by about $470 a month.
A rooftop deck is seen on a four-bedroom model home at Landsea Homes at Alameda Marina.
Lea Suzuki/The ChronicleDivide $21,000 by $470 you get 36 months, which is the breakeven point. A borrower who kept the loan for more than three years would come out ahead. The longer it was kept, the bigger the benefit.
If a buyer knew for sure that rates were coming down soon, it might be better to take the higher rate with no points and refinance when rates drop, although refinancers will generally have to pay some closing costs again.
“If you are going to sell or refinance in a few years, paying points doesn’t make sense,” said Jeff Ostrowski, a Bankrate analyst.
Some buyers get permanent buydowns because they need a lower rate to qualify for a loan, said Jason Barnes, mortgage sales supervisor with U.S. Bank in Campbell.
Buyers pay for permanent buydowns, but in a slow market they might be able to negotiate a credit from the seller at closing to help pay for it.
How temporary buydowns work
With a temporary buydown, the borrower typically takes out a 30-year fixed-rate loan but makes payments based on a lower interest rate during the first one, two or three years in exchange for a one-time payment that is deposited into an escrow account at closing.
The upfront payment is about equal to the interest savings during the discount period.
During this period, the borrower makes payments at the lower rate and the mortgage servicer draws from the account to make up the difference. At the end of the discount period, the borrower makes the full payment.
Suppose the note rate is 7.5%. With a 1/0 buydown, the buyer makes payments based on a 6.5% rate the first year and 7.5% in years two through 30.
With a 2/1 buydown the borrower pays at 5.5% the first year, 6.5% the second year and 7.5% in all remaining years.
New homes being built are seen in the window of a bedroom in a model home at Landsea Homes at Alameda Marina.
Lea Suzuki/The ChronicleThree-year buydowns are available but not too popular because of the steep price.
The borrower generally must qualify for the loan based on the note rate stated in the loan agreement, in this case 7.5%.
Most lenders require sellers to pay for temporary buydowns, meaning the cost comes out of their proceeds at closing. If the buyer has no choice between a true seller-paid buydown and a lower price, there’s little reason not to take the buydown.
In competitive situations, buyers might need to increase their purchase price to cover some or all of the buydown payment, in which case they’re paying for it indirectly. Here the cost/benefit analysis gets more complicated.
A real-life example
When Shatto and Nelson bought their “cute little 1927 Tudor revival” in Oakland, they took out a 30-year loan with a 2/1 buydown from LaSalle Mortgage, Shatto said. They’re paying based on a rate of 4.125% for the first year, 5.125% the second and 6.125% thereafter.
Over the first two years, the buydown will save them $15,470 in interest, which was the cost of the buydown.
Although the seller paid for the buydown, the buyers paid a higher price to compensate, said their agent Lindsay Ferlin of Red Oak Realty.
Did they make a good deal? Here’s one way to look at it.
They paid $866,000 and, with a 20% down payment, and borrowed $692,800. Had they not used a buydown and paid $15,470 less, they would have borrowed $680,424 with 20% down.
New homes are seen under construction through the window of a model home at Landsea Homes at Alameda Marina.
Lea Suzuki/The ChronicleWith the higher loan amount, they’d repay an extra $27,071 over 30 years — consisting of $14,695 in interest and $12,376 in principal. But during the first two years, they’d save a total of $15,470, and most people don’t keep a mortgage for 30 years.
“Outside of a few cases, this does not have a significant economic benefit for borrowers,” said David Reiss, a professor of real estate law at Brooklyn Law School. “It’s a little bit of smoke and mirrors. I don’t think it improves their financial condition other than in a few cases where you have a low income in the present and expect it to grow significantly after a couple of years.”
Temporary vs. permanent — or no buydown at all?
“The 2/1 buydown might not be relevant in every market but it is certainly relevant in ours,” Ferlin said. “It allows buyers to take advantage of the lower competition and depressed prices of certain properties in our current market to get into a home now. If they waited until rates went down, they would likely face massive competition and increased prices.”
Barnes pointed out that money in the escrow account belongs to the buyer. If the buyer refinances and there’s money left in the account, it will reduce the balance on the original loan. That’s not the case with a permanent buydown, he said.
Buydowns were not common when rates were below 4% because they didn’t save much money, said Guy Cecala, publisher of Inside Mortgage Finance.
When rates crossed 4%, permanent ones became popular because “there was still an emotional attachment to paying less than 4%,” Brady said.
As rates surged higher, some buyers became more interested in temporary buydowns because they don’t think rates will stay this high for long. “Consumers are very cautious about how much they are going to pay in points when the expectation over the next 18 months is that interest rates are going to come down,” Brady added.
Santos said most buyers of new Landsea homes still prefer permanent buydowns, but some are choosing a 2/1 temporary one. “They are taking a bet, ‘By the time I get to my third year, I’m hoping to refinance at a lower rate.’ ”
A living room and dining room in a four-bedroom model home at Landsea Homes at Alameda Marina.
Lea Suzuki/The ChronicleBuyers should ask their loan officer to run scenarios showing the cost and benefit of a temporary buydown, a permanent one and none at all. They should also be aware of the following pitfalls and limitations on buydowns:
• Temporary buydowns are not available on manufactured homes or investment properties. Some lenders may not offer them on jumbo loans, which exceed Fannie Mae’s and Freddie Mac’s loan limits ($1,089,300 in most Bay Area counties).
• Fannie Mae, Freddie Mac and the Federal Housing Administration limit how much money sellers, builders or real estate agents can contribute toward closing costs that are the buyer’s responsibility. These “interested party contributions” include payments for temporary or permanent rate buydowns, appraisals and other closing costs. They could limit how much sellers can pay for buydowns.
• Raising the purchase price to compensate the seller for a buydown could cause appraisal issues if there are not enough comparable home sales to support the higher price.
• In California, raising the price will permanently raise your property taxes by a little more than 1% of the increase. Paying $20,000 more for a home will raise your taxes by about $200 per year.
• If a price increase raises your loan-to-value ratio above 80%, you would have to pay for private mortgage insurance, and you’d likely pay a higher interest rate, Cecala said. If your down payment is less than 20%, “you might be better served increasing your down payment” than paying for a buydown, Ostrowski said.
• Freddie Mac found that homeowners who got temporary buydowns received note rates that were 0.15 percentage point higher on average, meaning they’d pay more for the life of the loan. “This trade-off isn’t surprising since the lower initial payments need to be made up by either higher upfront charges, a higher rate, or both,” it said.
• In a bidding war, requesting a buydown could put buyers at a disadvantage. “Most sellers want the quickest, fastest, simplest buyer … coming the closest to the asking price,” Brady said.
• Mortgage servicers are not supposed to report interest paid by a seller as interest paid by the buyer/borrower on Form 1098, the Internal Revenue Service says. This includes money deposited into an escrow account by the seller as part of a temporary buydown. It also means buyers shouldn’t be able to deduct interest coming from the seller-funded escrow account on their tax returns.
• There may be better ways to save money on a mortgage, such as making extra principal payments when your budget allows. “Any extra payment goes toward principal and that can save quite a bit of money,” said Molly Boesel, principal economist with CoreLogic.
Kathleen Pender is a freelance writer. Email: kathpender84@gmail.com; Twitter: @KathPender
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