What is a mortgage rate buydown and how does it work?

Rising mortgage rates have pushed potential home buyers to the sidelines and slowed home sales. In an effort to simulate the sluggish market, both sellers and mortgage lenders have begun to woo would-be homeowners with rate buydowns and discount points that make home loans more affordable for buyers.

“Those kinds of products have been around and typically only get utilized when lenders are desperate to create a need for a consumer,” says Gordon Miller, president of North Carolina-based Miller Lending Group.

So before you use a rate buydown or discount points to lower the interest rate on your mortgage, it’s important to understand how they work and when it makes sense for you.

You’ll generally pay 1% of the total loan amount for each point and receive a 0.25% rate reduction, but the cost and discount vary depending on the market and lender. “What you get with one point from one lender could be worlds different than with another lender,” says Jennifer Beeston, mortgage educator and senior vice president at Guaranteed Rate.

What are temporary buydowns?

A temporary buydown lowers the interest rate to a certain percentage, which then increases each year until it returns to the original rate. Common temporary buydown terms are 2-1 and 1-0, where the first number is the rate reduction you receive in the first year and the second number is the rate reduction for year two.

With a 2-1 buydown, a 6.25% mortgage rate would be cut to 4.25% the first year, increase to 5.25% in year two and return to 6.25% in the third year. Here’s what that looks like for a $350,000 loan balance.

A temporary buydown is typically paid for by either the seller, homebuilder or lender and it effectively offsets a portion of the buyer’s monthly payment. From the example above, it would cost $7,860 for the full 2-1 buydown, which is the total amount the buyer saves. The money used to lower the buyer’s monthly payments is deposited into an account and taken out each month by the mortgage loan lender. Keep in mind, with a temporary buydown the borrower needs to qualify for the home loan based on the full interest rate after the buydown expires.

Regardless, of whether or not a rate buydown makes sense for your situation, you want to ensure you’re getting the best deal from the start. And if you’re not comparing offers from multiple mortgage lenders, there’s a good chance you’re leaving money on the table. Select ranked the lenders below as some of the best mortgage lenders on the market:

If you’re paying for a discount, it’s important to always understand what you’re getting in return. Paying for a lower rate over the full 30-year loan term may look like it’ll save you money in the long run, but that doesn’t account for how likely you are to sell the home, refinance your loan or pay off your mortgage early. In each of those cases, the fees you pay upfront could end up being higher than what you saved. And researchers have shown that “borrowers overestimate how long they will stay with the mortgage.”

A temporary buydown can make sense since the buyer isn’t the one paying for it. However, even in that scenario, a buydown could come at the cost of other seller concessions. So you’ll want to consider the tradeoffs by asking yourself these three questions:

1. Could you get the same rate by refinancing later?

Whether or not you can refinance depends on several factors, including the type of mortgage.

For conventional loans, you’ll need at least 5% equity (loan-to-value of 95%) for a rate and term refinance, but you’ll typically only get the best rates if you have 20% equity in your home or more. Right now there are very few cases where it makes sense to buy down the rate, Beeston says. However, if the borrower took out a conventional loan with 3% down, “I think it can make sense because if rates drop they likely will not have enough equity to refinance immediately.”

There are streamlined refinancing options for both FHA and VA loans, which can make refinancing simpler with these loans than with a conventional loan. So it may make less sense for these types of borrowers to pay for a lower rate. “The last thing I want is my veterans spending a nickel to buy down a rate that they’re likely to refinance within the next year because then it’s just lighting money on fire,” she says.

Every time you refinance you have to consider the upfront closing costs. Your exact closing costs vary depending on the lender, the loan, where you live and the amount you’re borrowing. But refinance fees are thousands of dollars on average and can easily wipe out any potential savings you get by securing a lower rate.

However, you may be able to negotiate with the lender to receive credits to cover your fees in exchange for a higher interest rate. Lender credits are essentially reverse discount points and you may be able to use them to avoid fees when you refinance.

2. What are you giving up for the buydown?

Recently the housing market has shifted and sellers are working harder to entice buyers. “Because of the market we’ve been encouraging our clients to get the seller to pay closing costs, and we’ve had really good success with that,” Beeston says.

Just keep in mind that when sellers offer a buydown, that money has to come from somewhere. And funding the buydown might come at the cost of the seller reducing the overall purchase price or paying for closing costs. Depending on your preferences and financial situation, those concessions may be more important to you than a buydown.

3. Is this a good deal without the discount?

With any sort of buydown or discount points, you’ll want to ensure the starting rate is a good deal. Always compare loan offers from multiple lenders to ensure any discount is based on the best deal you can qualify for.

“Never get one [quote] because the industry can operate like a bad flea market,” Miller says. And be wary of any lender that is willing to price match because, “that’s more a game of, Oh, I guess you called someone else and found out I was charging too much. Okay. Got me. I’ll match it,” Miller says.

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