2-1 Buydown Program for Home Buyers – Yes or No?

Recently, lenders and real estate agents have been promoting a 2-1 Buydown Program.

So…should you consider it? If you are buying a home, will a 2-1 Buydown provide relief from high interest rates?

This article covers:

• What is the 2-1 Buydown Program? How does it work?
• What is the 3-2-1 and the 3-1-1?
• How much will I have to pay long-term?
• What other mortgage programs are available?
• Why is the industry promoting a 2-1 Buydown program?
• Which is better: 2-1 Buydown or Paying Points?
• Where to get more information about interest rate reduction programs

What is the 2-1 Buydown Program? How Does it Work?

The easiest way to explain how this loan program works is to show an example.

Let’s say you want to buy a house that costs $1,000,000, with a 20% down payment. That’s a $200,000 down payment and an $800,000 loan. In this example, the current mortgage rate is 7%.

How the Rate Changes

The amount of interest you will pay, although set at 7%, will temporarily decrease. The seller will pay the difference, so that the bank receives 7%.

In a 2-1 Buydown, your interest rate will decrease by 2% for the first year. Then, the rate will decrease by 1% for the second year. Finally, the rate will go back to the original amount for the remainder of the loan period.

Our example:

$800,000 loan at 7% – monthly principal and interest payment is $5322.42. 

The Seller chooses to participate in a 2-1 Buydown, which means that they pay a credit of $18,646.39.

Year 1: If the rate adjusts to 5% – principal and interest payment will be $4294.57. This is a savings of $1027.85, or $12,334.20 for the year.

Year 2: If the rate then changes to 6% – principal and interest payment will be $4796.40. This is a savings of $526.02, or $6,312.19 for the year.

Total interest savings for the first two years: $18,646.39. This savings is paid by the seller.

An Escrow Account Holds the Funds

When you close the loan, an escrow company takes the seller credit, which is equal to the total savings amount. In our example, that would be $18,646.39. The escrow company holds the funds for the lender.

Each month, the escrow account sends the monthly “savings” to the lender. In our example, the lender receives $1027.85 each month during year 1, and then $526.02 each month for year 2.

In this way, the 2-1 Buydown is a payment subsidy. The lender doesn’t make any more money. Rather, the cost of the interest is simply shared between the buyer and seller.

What Happens If I Sell Before Year 3?

If you sell during the first two years of ownership, the escrow company will refund to you the balance of the funds. This is because the money belongs to you – no matter whether or not you own the property.

However – the credit that you receive cannot exceed your total closing costs. This “no cash out” rule applies to any credit you receive as a borrower.

The seller would receive any amount that exceeds your total closing costs.

What is the 3-2-1 and the 3-1-1?

Just like the 2-1 program, there are other ways to structure the rate change.

For example, with a 3-2-1 loan, you receive a 3% discount during the first year. Then, you receive a 2% discount during the second year. Finally, you receive a 1% discount during the third year. Upon the beginning of the fourth year, the rate returns to the original amount.

A 3-1-1 loan is like a 3-2-1 loan, except that after the 3% discount for the first year, you only get a 1% discount for years 2 and 3. For both programs, at the end of year 3, you go back up to the original interest rate.

How much could a 2-1 Buydown cost long-term?

Using our example, let’s say that you can’t refinance because the mortgage rates never decrease. Let’s assume that the best rate you can get will always be 7%.

If you keep the loan for the full 30 year term:

Total interest for 30 years at 7%: $1,116,071 minus $18,646 seller credit = $1,097,425 total interest paid

Keep in mind that many people assume that rates will go down in the future, so that you will be able to refinance. This, of course, is not a certainty.

When you take out a mortgage, you should anticipate keeping whatever rate you first receive.

What other mortgage programs are available?

In general, there are two other options that could save more money.

Pay points, bring down your rate

It is impossible to know future rates. You can, on the other hand, lock in a lower rate at the very beginning of the loan.

Instead of the 2-1 Buydown program, you can simply pay points in exchange for a lower interest rate.

In our example, the Seller is willing to give the Buyer a credit of $18,646. Instead of the 2-1 Buydown, the Buyer could use that credit to permanently lower the rate.

If a Buyer applies the Seller’s $18,646 credit as points to reduce the rate, the rate may go from 7% to 6%. This is a permanent reduction of the rate.

Total interest for 30 years at 6%: $926,708

This is $170,717 less than the 2-1 Buydown program.

Apply the seller credit toward your purchase price

If you don’t need to buy down the rate, you can simply lower the purchase price. This increases your equity from the beginning, and slightly lowers your property tax and mortgage payments.

In our example, a Seller credit of $18,646 would lower the price from $1,000,000 to $981,354:

• The loan amount would be $785,083. With a 7% interest rate, that’s $1,095,258 total interest paid over 30 years.
• The total monthly principal and interest payment decreases about $100 per month.
• The 20% down payment would be $196,271, a savings of $3729 up front.
• The property tax savings would be approximately $224 per year.

Conclusion: it likely makes the most sense to buy down the interest rate up front. You save the most money over the long run.

Why do lenders promote the 2-1 Buydown program?

You might think lenders make more money with this program. Actually, that’s not true. 2-1 Buydowns don’t provide the lender with more money. The only difference is that the seller temporarily pays a portion of the monthly payment, from the escrow account.

The reason why the real estate industry promotes this program, is simply to encourage buyers to write offers. If buyers feel that there’s a new option to make financing possible, they may feel more motivated to buy a home.

With rising interest rates, a home seller benefits from offering a credit. If an $18,000 credit will help sell a home more quickly, without having to reduce the list price, it likely makes sense for a seller to offer some money up front.

Keep in mind, though, that the Buydown program doesn’t make mortgage qualification any easier. The borrower still needs to qualify for the higher rate.

2-1 Buydown vs. Paying Points – Cost Comparison

Here are three scenarios, with resulting long-term costs. You’ll see that the 2-1 Buydown doesn’t offer more savings than paying points. If interest rates don’t decrease substantially after two years, the 2-1 Buydown will cost you more money long-term.

Scenario #1: If Rates Drop FOUR Points After 2 Years

Let’s say that rates are currently 7%, and you choose the 2-1 Buydown.

After year 2, rates drop to 3%, and you refinance. You will have paid 5% interest the first year, 6% interest the second year, and then you pay 3% for a 30-year refinance.

Finally, let’s compare this “ideal” situation to simply using the $18,646 credit to reduce the rate to 6% at the very beginning.  In both scenarios, we refinance at the end of year 2, when rates drop to 3%.

2-1 Buydown, rates drop to 3% after 2 years

You take the 2-1 Buydown at 7%. Then, rates drop down to 3% at the beginning of year 3.

• Interest paid during the first two years: $110,898 minus $18,646 seller credit = $92,252
• Total interest paid for a 30 year refinance ($783,100 remaining principal balance) at 3%: $405,470
• Refinance costs: $5000

$92,252 + $405,470 + $5,000 = $502,722

Pay Points, rates drop to 3% in 2 years

You use the seller credit at the beginning to pay points to get a 6% rate. Then, rates drop down to 3% at the beginning of year 3.

• Interest paid during the first two years (6%):  $94,860
• Interest paid for a 30 year refinance ($780,000 remaining principal balance) at 3%: $403,864
• Refinance costs: $5000

$94,860 + $403,864 + $5,000 = $503,724

At the end of the loan, there’s almost no cost difference between these programs.

Scenario #2: If Rates Drop TWO Points After 2 Years

Let’s say that rates are currently 7%, and you choose the 2-1 Buydown.

After year 2, rates drop to 5%, and you refinance. You will have paid 5% interest the first year, 6% interest the second year, and then you go back to 5% for a 30-year refinance.

Finally, let’s compare this to using the $18,646 credit to reduce the rate to 6% at the very beginning.  In both scenarios, we refinance at the end of year 2, when rates drop to 5%.

2-1 Buydown, rates drop to 5% after 2 years

You take the 2-1 Buydown at 7%. Then, rates drop down to 5% at the beginning of year 3.

• Interest paid during the first two years: $110,898 minus $18,646 seller credit = $92,252
• Total interest paid for a 30 year refinance ($783,100 remaining principal balance) at 5%: $730,286
• Refinance costs: $5000

$92,252 + $730,286 + $5,000 = $827,538

Pay Points, rates drop to 5% in 2 years

You use the seller credit at the beginning to pay points to get a 6% rate. Then, rates drop down to 5% at the beginning of year 3.

• Interest paid during the first two years (6%):  $94,860
• Interest paid for a 30 year refinance ($780,000 remaining principal balance) at 5%: $727,395
• Refinance costs: $5000

$94,860 + $727,395 + $5,000 = $827,255

Even if rates drop two points in two years, there’s still a tiny difference in total costs between the two programs.

Scenario #3: If Rates Drop ONE Point After 2 Years

Here’s one final comparison: what if rates drop only one point, down to 6%, at the end of two years?

2-1 Buydown, rates drop to 6% in 2 years

You take the 2-1 Buydown. Then, rates drop down to 6% at the beginning of year 3.

• Interest paid during the first two years: $110,898 minus $18,646 seller credit = $92,252
• Total interest paid for a 30 year refinance ($783,100 remaining principal balance) at 6%: $907,129
• Refinance costs: $5000

$92,252 + $907,129 + $5,000 = $1,004,181

Pay Points, rates drop to 6% in 2 years

You use the seller credit at the beginning to pay points to get a 6% rate. The rate stays at 6%, so you don’t refinance.

Interest paid during the 30 year loan:  $926,708

Conclusion: If rates drop only one point after two years, paying points will save you $77,473 over the 2-1 Buydown.

No one knows the future of interest rates. This is why we believe that the 2-1 Buydown is risky. You should only do it if you’re comfortable with the rate set for years 3-30.

I have more questions! Where can I get help?

You are always welcome to contact me anytime. You can also read my articles about:

Conventional Home Loan Programs
Buyer Closing Costs
Concurrent Closing – Selling and Buying a Home at the Same Time
Where Can I Go to Get a Mortgage? – Mortgage Lenders 101

If you have lending questions, contact Nick Richardson – his information is below.

I couldn’t have written this article without the expert advice of Nick Richardson:

Nick Richardson is a mortgage banker with EZ Fundings in San Diego, California, NMLS #966361. He can help you finance or refinance properties located in California. Nick can answer all of your questions about mortgage programs, with no hassle, no obligation. Contact him at 760-402-6962 or e-mail nick@ezfundings.com.