The 2-1 Buydown could open up homebuying options
In 2022, mortgage rates rose from 3.22% in January to 5.13% in August, says mortgage industry giant Freddie Mac.
On a $350,000 loan, that’s a $400-per-month increase, no small amount for a first-time homebuyer (or any homebuyer; let’s be honest).
Luckily, there’s a mortgage option re-emerging that no one has talked about since the 90s: the 2/1 Buydown program.
This program effectively reduces your rate by 2% the first year, 1% the second year, and you keep your base rate in years 3-30.
Is this program for you? Let’s take a deeper look.
What’s in this article?
What is a 2/1 Buydown?
A 2/1 Buydown is an add-on feature that effectively reduces your interest rate for the first two years. This makes homeownership more affordable during the most expensive and important years of homeownership.
Someone involved in the transaction, such as the seller, builder, or even you as the buyer, prepays enough interest to make it “feel” like you have a lower interest rate temporarily.
|Year 1||Rate reduced by 2%|
|Year 2||Rate reduced by 1%|
|Years 3-30||Standard rate|
Here’s how the scenario might play out for the buyer, using hypothetical rates.
|Year||Effective interest rate||Payment ($300k loan)|
In this scenario, the buyer saves $356 per month in year one and $183 per month in year two. These savings could go a long way as the new homeowner adjusts to making a house payment while juggling other costs of homeownership like repairs, new furniture, and maintenance.
A 2/1 Buydown could make the difference between feeling comfortable buying a house and not for a prospective buyer.
How many discount points does a 2/1 Buydown cost?
It’s understandable to think that someone “buys down” the interest rate itself. After all, that’s what the name “2/1 Buydown” suggests.
But that’s not what’s happening. Rather, the rate stays the same for the entire loan period and a portion of the payment gets prepaid at the time of closing. Let’s look at the above example again, this time calculating how much it would cost to perform the buydown on a $300,000 loan at a 5.5% rate.
2/1 Buydown example
|Year||Standard Payment ($300k)||Buydown payment ($300k)||Monthly difference x12|
|1||$1,703 at 5.5%||$1,347 at 3.5%||$356 x 12 = $4,272|
|2||$1,703 at 5.5%||$1,520 at 4.5%||$183 x 12 = $2,196|
In this transaction, the seller, home builder, or buyer would kick in $6,468 at closing to prepay a portion of the buyer’s payments for the first two years. That’s the equivalent of paying 2.16% discount points.
Keep in mind, though, that the “discount point equivalent” will change with every loan scenario. The loan amount and starting interest rate will affect it.
Remember that this program doesn’t actually buy down the rate itself. Rather, it reduces the payment to the point that it seems like you have a lower rate.
2/1 Buydown versus adjustable-rate mortgage (ARM)
As mentioned, the 2/1 buydown is actually just a fixed-rate mortgage where a portion of the payment is prepaid for two years. The rate itself never changes.
An adjustable-rate mortgage, though, comes with an initial teaser rate which can adjust upward after the initial fixed period.
2/1 Buydown pros
- Predictable payment in years 1-2 and 3-30.
- Use seller or home builder funds to prepay a portion of the payment
- Combat rising interest rates
2/1 Buydown cons
- Guaranteed payment increase after years 1 and 2
- Substantial upfront costs at closing
- May not be compatible with some loan types
Adjustable rate pros
- Get a rate that’s about 0.50-1% below current 30-year fixed rates (check with your lender on the current difference
- Choose between a 3, 5, or 7-year initial fixed rate period
- No required upfront costs at closing to buy down the rate/payments.
Adjustable rate cons
- The rate could rise 1-2% after the fixed period and up to 5-6% during the life of the loan for most ARMs
- Unpredictable payments after the initial fixed period.
Why would a seller or builder pay for a buydown?
The housing market is shifting.
In 2020 and 2021, home builders and sellers could ask almost anything they wanted when selling a home.
Now that rates are higher, those days are gone. In fact, many markets could already be seeing price reductions and seller concessions.
When a home seller really needs to sell a home, they offer incentives like seller-paid closing costs. For example, the seller could offer 2% of the home’s price towards closing costs.
On a $350,000 home, that’s $7,000 and enough to pay for the 2/1 buydown in the example above.
As your shopping for a home, find one that has been sitting on the market. See if you can get the seller to pay for your buydown.
2/1 Buydown requirements
The 2/1 Buydown program won’t work in every situation.
Additionally, the cost of a 2/1 buydown will count toward the interested party contribution (IPC) limit, if paid by a builder, seller, agent, or lender. A conventional loan with less than 10% down has a maximum IPC of 3% of the home’s price, or $9,000 on a $300,000 home.
Funds needed for a 2/1 Buydown could eat up most of this limit.
Some lenders will only allow a buydown on a one- or two-unit home: no triplexes or four-plexes.
But no matter what your scenario, check with your lender. If your lender can’t complete your transaction, call around, because another lender might.
Best candidates for a buydown
You might consider a 2/1 Buydown if:
- Your income could increase within two years
- You or a spouse will return to work within two years
- You want to reduce costs of the first years of homewnership to pay for repairs and other upfront costs
- You want a low initial payment but don’t want an adjustable-rate mortgage
Payment used to qualify / debt-to-income (DTI) ratios.
You’ll still need to qualify for the full payment. The lender can’t qualify you using the reduced payment for year one or two, since those are temporary.
For example, your debt-to-income ratio is 50% using the full payment, which is a little too high for most loan programs. You can’t use the reduced first-year payment to lower your DTI.
A 2/1 Buydown is when a home seller, builder, or buyer contributes money toward the buyer’s first two years of payments such that the effective rate is 2% lower the first year, 1% lower the second year, and carries the standard rate in years 3-30.
The cost will vary based on loan amount and interest rate. On a $300,000 loan with a 5.5% rate, the 2/1 buydown would cost $6,468, or 2.16% of the loan amount. There is no set percentage, though, since a buydown prepays a portion of the payment for two years. It does not use discount points to buy down the actual rate.
A 3-2-1 Buydown reduces the payment the same as if the rate were reduced 3% the first year, 2% the second year, 1% the third year. The standard payment would apply in years 4-30.
A 1-0 Buydown buys down the effective rate by 1% the first year. The loan returns to its standard rate in years 2-30.
Get started on your 2/1 Buydown
A buydown can help the right kind of buyer afford homeownership in the critical first few years.
The 2/1 Buydown could be a great tool as you adjust to making a home payment, plus cover expenses like repairs and upgrades.