Compare a conventional loan to a temporary buydown

Save Tens of Thousands With a 2/1 Buydown Mortgage

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You have probably read several recently claiming that renting is now cheaper than owning a home. If you only look at the monthly cost over the first year (or few years) that is true in most cities. However, as I’ve written before in my article Rent vs. Own, , over the long run owning is actually a much better financial decision.

But first-time homebuyers must choose between renting, or buying with monthly payments maybe two or three times as high. Their worries shouldn’t be dismissed. The decision is an important one.

Why Has the Cost of Owning Gone so High?

The primary cause, in my opinion, is low housing inventory. You studied supply and demand in college, so you know that very low supply relative to demand means upward pressure on prices. In fact, despite the job market and wage increases cooling off recently, home prices are still rising according to the S&P Case-Shilling Home Price Index.

Home prices continue to rise sharply with no end in sight
Home prices will continue to rise as long as we have a shortage of inventory

Interest rates are also pushing the cost of homeownership up. From an historical perspective, you can see from the chart below that current interest rates are not that high. But they are much higher than they were over the last 20 years, and that’s what homebuyers use as a measuring stick.  The high interest rates also contribute to low housing inventory, since homeowners with mortgages at or below 3% are loathe to give them up.

30-Year Mortgage Interest Rate Average
Interest rates are higher than a few years ago but not high by historical standards

The combination of having to double or triple your monthly housing cost, and get into a bidding war to buy a home keeps current homeowners from jumping into the seller market. As long as that continues, owning a home will cost you two or three times as much each month as renting in most of the country, and even more in certain high-cost areas.

Owning is Still Better in the Long Run

As the article referenced above points out, buying real estate with a mortgage is the only investment that most people can leverage. By borrowing money to purchase the asset you can make money by using other people’s money. Your return on your investment is multiplied many times over because of this.

Your equity in real estate invariably grows over time, because your home is appreciating, and you are paying down your mortgage. Homeownership is a terrific long-term investment.

Further, owning a home has other benefits as well, such as stability, security, and pride of ownership. I’ve yet to meet a family who dreams of raising their children in a rental.

Nevertheless, first-time homebuyers face a daunting decision—rent, or commit to many times the monthly expense to own. We can’t do much about interest rates, but we can use little-known hacks to lower your cost the first few years to ease the pain. In this article, we are going to explore the seldom used temporary buydown, which deserves a lot more consideration than it’s getting.

What is a Temporary Buydown?

A temporary buydown is a feature available on mortgages where a home buyer can pay extra money up front to lower their interest rate for 1, 2 or 3 years.

The interest rate for a mortgage is set in the NOTE. With a temporary buydown the interest rate is reduced initially. A 2/1 buydown, for example, would mean that in year on the interest rate would be 2% lower than the permanent rate, and 1% lower in the second year. For the remaining 28 years the interest rate would be whatever the note rate is.

As an example, if we selected a 2/1 buydown on a NOTE with a permanent interest rate of 7%, the interest rate in year one would be 5%, in year two 6%, and beginning in year three the rate would be 7% until the loan was paid off.

So, do we just ask for a temporary buydown? Yes, but there is a cost to do this, naturally. How much cost depends on the lender and changes from time to time. This is where having a mortgage broker shop for you can make a huge difference.

Let’s take a real example. Rates and costs in this example are valid for illustration only, and assume a 20% down payment for a qualified, creditworthy borrower. Rates and fees change all the time.

A typical Silicon Valley starter home in Silicon Valley might cost between $1.3 mm  and $1.8 mm. (Sorry to those elsewhere in the country – this is not a misprint.) But the ideas apply anywhere in the country.

We assume a purchase price of $1,437,000, with about 20% down and a loan amount of $1,149,600. (Above $1,149,825 temporary buydowns are not offered.)

As of this writing, the best price on a 2/1 buydown of this loan would be about 0.5 points, or $5,748 in extra up-front costs. As a homebuyer, you could choose to pay for this in cash if you had it available after your 20% down payment. But what if you didn’t have the cash?

You could ask the seller to give you a seller concession and pay for it. In a competitive market, this might fly. In today’s market, your chances of a seller agreeing are slim. (But not zero, so you can always ask your real estate agent.)

There is another way, however, You can also ask your lender to pay for it. How? If you accept a higher NOTE rate (permanent interest rate,) the lender will give you a credit in escrow toward some of your closing costs. In this case, for a bump in the interest rate of only 0.125%, they will pay for the 0.5 points in cost for the buydown.

NOTE: I’ve been making loans for a long time. The premium for the 2/1 buydown is lower than I’ve ever seen before, which prompted me to write this article. This is a bargain today.

Temporary Buydowns Offer HUGE Savings

Let’s take a look at the results.

Compare a conventional loan to a temporary buydown
You can save tens of thousands of dollars with this strategy

In this example a conventional 30-year fixed is available at an interest rate of 7.375%. The monthly payment would be $7,940, and the payment would not change for the life of the loan.

Let’s compare that to a couple of temporary buydown options.

But look at Option Two. With a premium of $5,748 for the 2/1 temporary buydown the interest rate in year one would be 5.375%, with a payment of $6,437, $1,503 per month lower than without the buydown. That is less than a four-month payback, and the savings continue. The interest rate in year two would be 6.375%, with a payment of $7,155, still well under the conventional loan. For your initial investment of $5,748, you will save $27,450 in payments the first two years. Subtract the cost of the points and your net savings is $21,702.

What if you don’t have the extra money up front and the seller won’t fund it? Let’s look at Option Three. Here we choose to take the higher interest permanent rate of 7.500% and let the lender fund the cost. Your interest rate in year one is 5.500% for a payment of $6,527, and in year two 6.500% for a payment of $7,171. The two-year savings are even more impressive since the cost for this is zero points. Now your total outlay for two years is $26,185 less than a conventional loan.

And did I mention there’s more? The lower your interest rate the faster you pay down your loan balance, so after two years you will owe much less with the buy down than you would have with a conventional loan. Let’s add $5,000 to $7,000 to the savings above. And, if you haven’t refinanced into a permanent loan by then, starting in year 3 your permanent payment will be lower forever, since your loan balance will be lower.

In the past the cost of a temporary buydown was about a break-even, but it took some of the payment shock pressure off the first two or three years of ownership. But today, lenders are trying to get your attention. They got mine.

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Casey Fleming, Author The Loan Guide (2014) and Buying and Financing Your New Home, (2023 – Available as an e-book or hard copy wherever books are sold )

Mortgage Advisor, Silicon Valley Mortgage / Property Manager, Bright House Properties

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Resources Used for This Article

Renting vs. Owning a Home: What’s the Difference? – Investopedia

Renting is now cheaper than owning in all of America’s 50 biggest metro areas – Marketwatch

Understanding Housing Inventory and What It Means for You | Real Estate | U.S. News (usnews.com)

S&P CoreLogic Case-Shiller U.S. National Home Price Index (CSUSHPINSA) | FRED | St. Louis Fed (stlouisfed.org)

30-Year Fixed Rate Mortgage Average in the United States | FED | St. Louis FRED

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