How do you buy down your interest rate?

For homebuyers, the interest rate a lender charges can affect their budgets in both the long- and short-term. The higher the interest rate, the higher your monthly payment and the more you’ll pay in interest over the life of the loan.

There is a way to lower your interest rate by making an upfront payment to the lender. However, it’s helpful to know how buying down interest rates work and when it makes sense to do it.

What is an interest rate buydown?

An interest rate buydown occurs when a homebuyer or another party, like a seller or developer, negotiates with the lender to pay an upfront fee to lower their interest rate. This usually takes one of two forms: a permanent buydown using mortgage discount points, which are paid by the buyer or a temporary buydown, which is paid by the seller or another third party.

What is a permanent buydown?

Also known as an evenly distributed interest rate reduction, a permanent buydown allows homebuyers to purchase mortgage discount points to get a lower interest rate for the life of their mortgage. They do this by buying points, which are usually equal to 1% of the value of the loan. Each point could lower the interest rate by 0.25%, but the exact amount will depend on your lender.

When you buy mortgage points, you’ll need to pay upfront, but you can potentially save more money in the long run.

What is a temporary buydown?

Another way to buy down an interest rate is a temporary interest rate buydown. This can be done by a borrower, but it may also be used by sellers or builders as an enticement for homebuyers.

With a temporary buydown, the seller helps finance the buyer’s mortgage by paying the difference in cost of the interest rate for the first one to three years.ec-fanniemae-temporary-interest-rate-buydowns The buyer gets the temporary benefit of a lower interest rate at no cost to themself and the lender still receives the full monthly payment at the original interest rate.

How does a seller temporarily buy down a mortgage rate?

The seller can buy down a mortgage interest rate by paying an agreed-to amount, usually equal to the calculated savings for the buyer, into an escrow account at closing. The lender manages this account post-closing, and they’ll handle withdrawing funds to make up the difference in interest each month until the escrow account is empty.

Why would a seller buy down the buyer’s mortgage interest rate?

Home sellers may find it advantageous to set aside some of the profit from the sale of their home to provide a temporary interest rate buydown as an incentive for potential buyers. This may make sense in a buyer’s market, where supply exceeds demand, if a seller needs to sell a home quickly or has had trouble finding a buyer due to the location or condition of the home.

A home builder or developer may also find it beneficial to offer a temporary interest rate buydown to attract potential buyers in a competitive market or if they’re trying to sell the last few homes in a planned community or condo development. Chase does not allow temporary interest buydowns at this time.

How much does it cost to permanently buy down the interest rate?

The cost to buy down the interest rate for a mortgage loan will depend on whether you’re using a permanent buydown or a temporary buydown.

For a permanent buydown, if you had a $400,000 loan, you would pay 1% of the loan value or $4,000 per point. While you need to pay upfront for points, they can provide real savings over the life of your loan. Assuming a $400,000 mortgage with a 30-year-fixed-rate at 6% interest, your monthly payment would be $2,398.

Here’s how much each point purchased would affect your monthly mortgage payment if you started with a 6% interest rate and a monthly mortgage payment of $2,398.

• 1 point: Cost $4,000. New interest rate 5.75%. New monthly payment $2,334
• 2 points: Cost $8,000. New interest rate 5.5%. New monthly payment $2,271
• 3 points: Cost $12,000. New interest rate 5.25%. New monthly payment $2,209
• 4 points: Cost $16,000. New interest rate 5%. New monthly payment $2,147

Your total savings will depend on how long you keep the mortgage. Using the example above, If you were to buy two points for $8,000, you’d save $127 a month. If you divide your monthly savings by the amount you paid for points, you’ll reach your break-even point after 63 months. After that, you could save $1,524 per year on your mortgage.

The longer you keep your current mortgage, the more you’re likely to save.

How much does a temporary mortgage buydown cost?

For a homebuyer, a temporary buydown may cost nothing. But for home sellers, temporary interest rate buydowns are usually structured over a one to three year period and cost the difference between the reduced and original payment.ec-fanniemae-temporary-interest-rate-buydowns Different types are usually represented as a:

• 1-0 buydown
• 1-1 buydown
• 2-1 buydown
• 3-2-1 buydown

The numbers indicate how much the interest is reduced from the key interest rate for each year of the loan.

For the following examples, let’s again assume you’re borrowing $400,000 at a 6% interest rate. In each case, the amount you’d save would need to be pre-paid by the seller at closing.

1-0 interest rate buydown

A 1-0 buydown signifies that there is a 1% interest rate reduction for the first year. So for the first yearn you’d have a 5% interest rate and a lower monthly payment of $2,145, After that, you’d go back to a 6% interest rate and a monthly payment of $2,398

Total savings: For the first year, you’d save $253 each month on your mortgage payments and $3,036 in total.

1-1 interest rate buydown

This type of buydown comes with a 1% interest rate reduction for the first two years. So for both of those years you’d pay a 5% interest rate and have a monthly payment of $2,145. Starting in year 3, you’d go back to the 6% interest rate and the $2,398 monthly payment.

Total savings: For the first two years, you’d save $253 each month on your mortgage payments and $6,072 in total.

2-1 interest rate buydown

A 2-1 buydown means the buyer receives a 2% reduction for the first year and a 1% reduction for the second year. In this example, you’d only pay 4% interest the first year and have a monthly payment or $1,908. The second year you’d pay 5% and have a monthly payment of $2,145. After that, you’d return to the original 6% interest rate and a monthly payment of $2,398

Total savings: For the first year, you’d save $490 each month and in the second year, you’d save $253 each month. You’d save $8,916 in total.

3-2-1 interest rate buydown

A 3-2-1 buydown translates to a 3% reduction for the first year, a 2% reduction for the second year and a 1% reduction for the third year. In this example, your buydown would work as follows:

• Year 1: 3% interest rate and a $1,685 monthly payment
• Year 2: 4% interest rate and a $1,908 monthly payment
• Year 3: 5% interest rate and a $2,145 monthly payment
• Years 4 – 30: 6% interest rate and a $2,398 monthly payment

Total savings: For the first year, you’d save $713 each month. For the second year, you’d save $490 each month and the third year you’d save $253 each month. In total, you’d save $17,472.

Pros and cons of mortgage interest buydowns

There are benefits to buying down your mortgage interest as a homebuyer or receiving a temporary buydown from a home seller, but it’s important to weigh the pros and cons before you commit to a buydown.

Pros of a mortgage interest buydown

• Lower mortgage payments: If you’re able to benefit from a mortgage interest buydown, you’ll have a lower monthly mortgage payment, even if you buy the points yourself.
• More cash available: If someone else is paying for a temporary interest buydown, you can hold onto the extra cash or apply it toward your mortgage principal. If you pay for the points, the lower monthly payments could lead to a less strict monthly budget.
• Possible tax deduction: If you purchase points for a permanent buydown, you may be able to deduct them on your income tax return.ec-irs-home-mortgage-points However, it may be worthwhile to talk with a tax professional beforehand to better understand the implications of doing so.

Cons of a mortgage interest buydown

• Higher payments later: While your payments may be lower for the first few years with a temporary buydown, they will go up over time. If you don’t have the income to cover those payments, you may risk defaulting on your mortgage.
• Loss on investment: If you sell or refinance your mortgage before you reach your break-even point, you could wind up losing more than you’d gain.
• Tax deduction not available for investment properties: You can only deduct the buydown of the interest rate on a primary residence. The option isn’t available for investment properties.ec-irs-home-mortgage-points If you have additional questions related to potential tax implications, it may be worthwhile to seek out the advice of a tax professional.

In summary

Buying down interest rates can be a valuable way for homebuyers to pay less on their mortgage interest over the life of the loan. It can also serve as a helpful incentive for sellers to encourage more potential buyers.

Whether you choose to buy points or offer a temporary buydown will ultimately depend on how much you can afford to put down. It’s also helpful to talk to your lender to see if the benefits of a buydown outweigh the upfront costs.

Interest rate buydown: FAQs

Is it smart to buy down interest rates?

Buying mortgage discount points usually makes the most sense when interest rates are high due the economy or if your credit score is lower than it might be otherwise. It may also make sense if you can save enough of a down payment to avoid private mortgage insurance (PMI).

How much does 1 point buy down an interest rate?

For a permanent buydown, a point usually costs 1% of the value of the loan or $1,000 per every $100,000 borrowed. This usually lowers the interest rate by 0.25% per point. Some lenders may allow borrowers to buy half-points, which would lower the interest rate by 0.125%

Are there alternatives to an interest rate buydown?

If you’re concerned about how interest rates could affect your monthly budget, you could ask your lender about an adjustable-rate mortgage (ARM). You would get a lower interest rate for the first several years of the mortgage, but the rate would adjust annually after that depending on current interest rates.

If you plan on moving or selling your home before the introductory period ends, this could be a better option than buying down the interest rate on a fixed-rate mortgage.