2-1 Buydowns, a Magic Bullet or is there a Downside?

In the world of higher (and rising) mortgage rates, Real Estates Agents and Lenders alike are trying to come up with creative ways to keep homebuyers’ payments manageable.

In the world of mortgage financing, where numbers and percentages often rule the roost, the concept of a "2-1 Buydown" might initially sound like a cryptic financial term. However, beneath the jargon lies a creative and strategic approach that orchestrates a harmonious journey for homebuyers.

Imagine, if you will, a story of two symphony-loving friends, Alice and Bob, who are looking to purchase their dream homes. The aspire to be next door neighbors – and as luck would have it, their perfect homes appear for sale, right next to each other at the exact same list price. Let's dive into their story to unveil the intriguing concept of a 2-1 Buydown.

Our tale begins with Alice and Bob, two dear friends who share a passion for music and a lifelong dream of owning their own homes. They have found the perfect houses in the same neighborhood, but there's a catch – both houses come with mortgage rates that seem a tad high.

Alice, the pragmatist, is initially hesitant. She wants to ensure her monthly mortgage payments are affordable, so she doesn't feel financially constrained. Meanwhile, Bob, the optimist, is eager to secure his dream home and believes he can manage the higher monthly payments.  Enter a lender who can help the art of orchestrating financial solutions like a maestro conducting a symphony. He introduces Alice and Bob to the concept of a 2-1 Buydown.

"Imagine," The Lender begins, "that your mortgage is like a beautiful piece of music. It starts with a high note and gradually mellows out, creating a harmonious experience over time. The 2-1 Buydown can help you achieve that."

The 2-1 Buydown is like an overture that can set the stage for the entire symphony of homeownership. It is a temporary interest rate buydown that allows borrowers to pay a reduced interest rate for the first few years of their mortgage, making the initial payments more affordable.
For Alice, the lender suggests a 2-1 Buydown where the interest rate on the mortgage is 7.125%.

The first year: Alice will pay an interest rate that is 2% lower than the actual rate.  The second year: The interest rate will be 1% lower than the actual rate.

For Bob, who is more financially confident, is ok with riding the 7.125% as is.

Alice and Bob compare negotiation strategies on their respective homes – and Alice asks Bob why he isn’t interested in the same rate strategy that she is using? Bob replies that the answer is in the Seller Credit.  (Quick sidebar: A Seller Credit is money given back to the buyer at closing, usually in leu of receiving a lower sales price in order to offset closing costs outside of the down payment).

Bob explains to Alice that a 2-1 Buydown has to be 100% financed by a seller credit. For example, he says:

“Both of our mortgages would be $500,000. A 2-1 Buydown on your mortgage at 7.125% would require a Seller Credit of $11,721 (trust me on that math).

In year 1, your principal and interest payment would be $2722.43. In Year 2, it rises to $3,038.05, and then in year 3 thru year 30 on your mortgage it would be $3,368.59.

The Seller Credit gets placed in an escrow account held by the lender. The lender ALWAYS receives the 7.125% interest promised on the note. It’s just subsidized and pulled out one payment at a time by that Seller Credit. If you refinance your home during the first 2 years, the lender reduces the principal owed rather than returning the left-over money to you.

Essentially, you’d be using your seller credit to be slowly spilled to you over 2 years to offset your payments. I’d rather have all of it upfront at closing to pay for my appraisal, escrow and title fees, prepaid interest, and property tax prorations.”

As the years pass, the symphony of homeownership unfolds. Alice and Bob both enjoy their homes. Alice's payments gradually increase but remain within her comfort zone, while Bob embraces the joy of homeownership.
The beauty of the 2-1 Buydown is that it allows Alice to synchronize her financial paths with their homeownership dreams. Alice, the pragmatist, enjoys the initial financial ease, while Bob, the optimist, manages higher payments with confidence. In the end, they both reach the grand finale of their mortgage symphony.

As Alice and Bob sip tea on their respective porches, they reflect on their homeownership journey. They both agree that both of their negotiation strategies worked best for their individual situations. Bob was happy he didn’t have an initial cost upfront for those non-loan costs, and Alice was happy to have subsidized mortgage payments for the first 2 years.
The moral of the story: 2-1 Buydowns aren’t a panacea to these higher rates, but can manage to ease a homebuyer into their payments, especially if the plan is to sell or refinance inside of the first 3 years on the loan.
NOTE: I advise my clients to assume that rates DON’T come down during the 2-1 buydown period. I don’t want my client to be ‘house poor’ come the higher payment if the opportunity doesn’t come to fruition to refinance into a lower payment. In this scenario, the lender qualifies the buyer off the 7.125% payment – and not the subsidized ones. Buyers should do the same thing for themselves.

This article was written with the help of ChatGPT.com

* Specific loan program availability and requirements may vary. Please get in touch with your mortgage advisor for more information.

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