If all you want for Christmas is a 5% interest rate on a new mortgage, well I’ve got something to tell sell you. Today we’re going to talk about seller buydowns, which are all the rage in these days of that-costs-HOW-much-now interest rates.
I’ll start with what these are before getting to question of whether you should partake. Buydowns have been around forever, in which a home buyer puts in a lump sum of money up front in order to reduce the loan’s interest rate permanently. This is “buying points,” in the parlance. You pay 1% of the loan amount per point (points are generally worth .25% of the rate) to knock your rate down, so on a $500,000 loan you can pay $10,000 to bring your rate from 7% to 6.5%. It’s a prepayment of the interest on your loan, and as long as you’re staying in your house for a while and not planning to refinance quickly it’ll save you gobs of money over the course of the loan.
Seller buydowns are a bit of a different beast though. Due to lender rules these typically have to be paid by the seller of a house, and applied to a buyer’s closing costs (which can include mortgage points but not down payments). They’re also temporary. A commonly-offered program is called a 2/1 buydown, in which your interest rate is reduced by two percent in the first year of the loan, by one percent in the second year, and then it goes to the full fixed rate in the third year. There are also 3/2/1 buydowns, but you get the drift. They’re designed to bring the monthly payment down in the first couple of years, when new home buyers might need new quartz kitchen counters or a big-ass TV.
The mechanics of how these are constructed play a role in their execution. The seller has to agree to it, and they’re going to take a lump sum from their proceeds and put it into an escrow account held by the servicer of the loan. That lump sum will vary in cost, but figure around 2% of the price of the loan. Then, the servicer of the loan will apply that money to each monthly payment during the term of the buydown. In the example of the $500,000 loan at 7%, a 2/1 seller buydown will save the buyer about $11,000 over those two years, roughly equal to the amount that the buydown cost in the first place. Your monthly payment in the first year will be $643 lower, and $329 in the second year.
Having the money come out of an escrow account and applied over time is important, since the real goal with a seller buydown is to allow for refinancing prior to the moment when the loan goes to its full rate. I wrote about the perils of counting on a refi a few weeks ago, and I’m sticking to that. If, though, interest rates drop over the next couple of years, and if you maintain enough equity in the house, you could refinance and never pay that full rate. If you do so before the escrow money runs out, bonus! Those remaining funds will go to your payoff, which will offset some of the refi costs of $5-10k. If you had simply bought points up front as a buyer, some of that money is gone forever and you wouldn’t get the full advantage of a refi should it be available.
It sounds like free money for a buyer, but of course there are no free lunches. You, as a buyer, are asking the seller to make a concession that will cost them real money out of their pocket. Negotiation 101 says if you’re going to ask for THIS, you may not be able to ask them for THAT. Often, these buydowns will be offered in lieu of a price reduction on the house, and in that case who is really paying for it? And is this better than dropping the price of the house or just buying some points the old-fashioned way?
Well, let’s see:
In the 2/1 buydown you’re just getting the money up front more or less; it’s a temporary salve. The real reason to choose this option is if you’re sure that rates will come down and you can refinance. By the way, if you’re SURE of that, congratulations you just won finance and the stock market.
The $10,000 price drop saves you a couple thousand on your down payment (should you choose to structure it that way) and about double the value over the course of the loan. Your monthly rate is about $50 less than without the drop, so there’s no real oomph to it. But it’s there, and it’s real money.
The real savings is with a standard buydown, as reducing your rate by half a percent provides major returns over the term. It’s a $160 per month savings and $60,000 overall.
However! If you’re buying points up front in the standard buydown scenario, it will take five years for that monthly discount to equal the cost of the buydown. Let’s imagine a future, two years from now, in which interest rates go back to 5% and hopefully not because a global recession required this reduction, and you have enough equity in your house to refinance. Here’s how our scenarios look at this point:
The refi itself will drop your total costs by a couple hundred thousand bucks over the whole term, but the ultimate difference in savings between scenarios is minimal. That’s as long as the seller is paying for the initial buydown. If you paid for points yourself- reducing your rate from 7% to 6.5% at the beginning of the term- you would have recouped $3,800 of that $10,000 cost (via the savings each month) and would be essentially throwing away the other $6,200. A standard buydown makes the most sense when you’re not refinancing for at least five years.
Ok, now that your brain is thoroughly fried, what does it all boil down to? How should you spend this imaginary $10,000 that the sellers are going to give you? There’s no one answer since every situation is different, but generally:
If you think interest rates are going to drop in the near term- and the full fixed rate payment is affordable (that’s important!) both today and in two years- take the 2/1 buydown.
If you don’t think interest rates are going to drop anytime soon and you plan to stay in your house at least five years, take the standard buydown.
If you want slightly lower closing costs and a slightly lower payment, and the satisfaction achieved by negotiating a lower sticker price, take the price drop.
Four out of five lenders agree to ask your finance professional what’s best for you.
