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Week-End Review 09/01/2023

Understanding Temporary Buydowns in the Residential Mortgage Business

Buying a home can be both an exhilarating and daunting process. One of the key components to purchasing a home is securing a mortgage. While the residential mortgage landscape offers a variety of options tailored to meet different needs, one of the lesser-known options is the “temporary buydown.” This option can be especially beneficial to borrowers who expect their income to increase in the future but would like lower payments initially. Let’s delve into the mechanics and benefits of temporary buydowns.

What is a Temporary Buydown?

A temporary buydown is a mortgage financing technique where the borrower or the seller provides an upfront payment to the lender to temporarily reduce the interest rate and, consequently, the monthly payments for the early years of a mortgage. After the buydown period ends, the mortgage rate reverts to the original note rate, and the monthly payments adjust accordingly.

How Does It Work?

  • Typically, a temporary buydown is structured as a 2-1 or a 3-2-1 buydown.
  • 2-1 Buydown: The interest rate is reduced by 2% in the first year and by 1% in the second year. In the third year and thereafter, the rate goes back to the original note rate.
  • 3-2-1 Buydown: The interest rate is lowered by 3% in the first year, 2% in the second year, and 1% in the third year. From the fourth year onwards, the rate is the original note rate.

For instance, if a mortgage has a note rate of 6% and a 2-1 buydown is applied, the borrower would pay interest at a rate of 4% in the first year, 5% in the second year, and 6% from the third year onwards.

How is the Buydown Funded?

The funds for the buydown typically come from the borrower, the seller, or sometimes even the builder in the case of new constructions. The funds are placed into an escrow account, and the lender draws from this account to subsidize the lowered payments during the buydown period. The actual cost of the buydown can vary but is generally a percentage of the loan amount.

Who Benefits from a Temporary Buydown?

  • Borrowers: Individuals who expect their earnings to rise in the future might opt for a temporary buydown. This allows them to enjoy lower mortgage payments in the early years of the loan when their income might be lower.
  • Sellers/Builders: Sellers or builders can use temporary buydowns as an incentive to attract buyers. Offering a temporary buydown can make a home more appealing to potential buyers by providing them with a reduced monthly payment initially.

Advantages and Disadvantages

Advantages:

  1. Lower Initial Payments: The borrower enjoys reduced monthly payments during the early stages of the mortgage.
  2. Flexibility: Temporary buydowns offer flexibility for borrowers who anticipate higher earnings in the future.
  3. Increased Purchasing Power: With lower initial payments, a borrower might qualify for a larger loan amount.

Disadvantages:

  1. Upfront Cost: The buydown has an upfront cost that either the borrower, seller, or builder must pay.
  2. Higher Future Payments: Once the buydown period ends, the payments will increase to reflect the original loan rate.

To summarize, a temporary buydown can be an effective tool for those navigating the residential mortgage landscape. Whether you’re a borrower looking for initial financial flexibility or a seller trying to offer an attractive purchasing incentive, understanding how temporary buydowns work can help make the home-buying process smoother and more tailored to individual needs.