What is a Buydown?
A buydown, also known as paying points, is a way to lower the interest rate on a mortgage.
How Does a Buydown Work?
Let's say John Doe wants to borrow $100,000 to buy a house from Jane Smith. The lender says the interest rate on 30-year home mortgages is currently 5%. However, the lender also says that John can buy down the interest rate. To do this, John pays the bank, say, $1,000 now (usually 1% of the loan) and in return the bank changes the interest rate on the mortgage to 4.75%. This costs John more money up front, but it will lower his payments for the next 30 years.
There are different kinds of buydowns. A 2-1 buydown, for example, is a buydown that lasts two years and involves a series of increases over that time, up to the permanent rate. A 3-1 buydown is the same idea but spans three years instead of two.
Why Does a Buydown Matter?
Buydowns can apply to the entire term of a mortgage (in our case, 30 years) or for just a few years. The terms vary by lender, and sometimes homebuilding companies will pay for buydowns in order to attract buyers.
Sometimes, in order to close a deal, the seller of the property will offer to pay for the buydown. In our example, this would mean that Jane Smith pays the $1,000. However, Jane might just increase the price of the house by $1,000 to cover the expense.
It is important for buyers to weight the cost of the buydown against the monthly savings that come from lower payments. If the buyer only expects to be in the house for, say, five years, the buyer would pay more for the buydown than he ends up saving in lower monthly payments.