What Is Interest Rate Buydown?

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When you are offered to buy down your mortgage, it means that you will prepay an amount of money so that your mortgage payments will be lower in the early years. It is meant for people whose income will rise over the next few years but who want their mortgage payments to be less in the meantime. A mortgage buydown is a temporary fix, unlike paying extra upfront to reduce the interest rate on your mortgage loan.

How a Mortgage Buydown Works

Let's say that you have been offered a $350,000 mortgage at 6.75 percent, but you cannot afford to make the payments necessary to support it. You can buy down the interest rate to a manageable 3.75 percent the first year, a percent higher for the second year, then a percent higher for the third year. Instead of making monthly payments of $2,270, you will pay about $650 a month less during the first year, about $450 less per month during the second year, and about $225 less each month during the third year. In year four, you will begin making full payments of $2,270 each month, when your income, presumably, will be higher. The total reduction amounts to $15,853, which is the amount you will give to the bank. It will then tap your account for the difference between your payments and $2,270.

Benefits of a Mortgage Buydown

First, by using a mortgage buydown, you will be able to buy a more expensive home than you would ordinarily be able to afford because the monthly payments have been reduced during the early years. Second, rather than having the interest rate go up all at once along with the monthly payments, they increase incrementally. A mortgage buydown is an excellent way for someone whose about to get a degree that will lead to a higher income or someone whose spouse is about to return to work.

Drawbacks of a Mortgage Buydown

There are two negatives to this. First, a lender willing to offer you a buydown will pay no interest on your deposit. Second, you would be making money on the deposit if you put the money to work yourself instead of turning over to the lender under a buydown arrangement. For instance, if you were to invest the $15,853 in the above example at 5 percent compounded interest, you would earn close to $2,500 on that money over three years. With a buydown, you earn nothing on it.

Buydown Mortgage Versus Variable Rate and Interest-Only Loans

Many lenders offer a mortgage product with a variable rate. That means that if interest rates go up, in general, your rate and monthly payment will go up, too. Furthermore, to attract customers, many financial institutions offer a low introductory rate. However, instead of being able to budget for the gradual increases in rate, your monthly payments could rise faster than your budget allows. With interest-only loans, you will not be reducing the principal of the loan, and if that is combined with a decline in your home's value, your loan is said to be “under-water.”

Where Can You Get One?

Not ever lender is sophisticated enough to offer a mortgage buydown, especially those that do mortgages infrequently. So you'll need to call a number of banks and lenders to see if they offer that product.

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