If you’re keen to buy a house or apartment before rising mortgage rates and real-estate prices make homeownership less affordable, you may face an income hurdle.
In other words, you fail to meet lenders' debt-to-income ratio requirements. If you're in that position, you may find that a mortgage buydown helps you move forward
Mortgage Buydowns in Two Flavors
All buydowns allow you to purchase a lower mortgage rate. Suppose that in May 2013, you were quoted the average rate that month for a 30-year fixed-rate mortgage (FRM) of 3.54 percent. For an extra two points, however, you might have been able to buy down that rate to about 3.125 percent.
There are two forms of buydown. The traditional or permanent version buys a lower rate for the entire term of your mortgage. The temporary flavor allows you to purchase a low rate just for the first two or three years of your loan.
Both tend to be attractive to those who are cash-rich but have more limited incomes. Those who itemize tax deductions may also find they're able to claim for the cost of a buydown as an advance mortgage-interest payment, but it would be wise to take professional advice or consult the IRS's website before relying on this possibility.
Just like the closing costs associated with a mortgage, buydowns are generally quoted in "points", and each point is one percent of the total amount to be borrowed. The cost of buying down varies from lender to lender and sometimes from hour to hour, so you need to get firm quotes in order to model your potential savings. In general, however, it costs one point to buy your rate down by .125 to .25 percent for a 30-year fixed-rate mortgage (FRM).
Permanent Buydown Math
Once you have a firm quote, use a mortgage calculator to work out your monthly savings -- and, more importantly, the date on which your buydown investment breaks even. So if you borrow $200,000 with a 30-year FRM at 3.5 percent, your monthly principal and interest payment (excluding property taxes, insurances and so on) is $898.
To buy down your rate to 3.0 percent, you'd have to pay an additional $4,000 ($200K x 2 percent -- or 2 points) at closing. At 3.0 percent, your monthly payment falls to $843, a saving of $55. So it would take you just over six years (72.73 months) at $55 a month to break even. If you plan to stay in your new home for the full 30-year term of your mortgage, the savings could be considerable: 360 months x $55 = $19,800. Subtract your $4,000 initial outlay and you'd still be up $15,800.
However, if you think you might move before the break-even point is reached in year six, then you could find yourself actually losing money.
These temporary buydowns get you a lower rate for only a relatively short time: a 3-2-1 buydown drops your rate by three percent the first year, two percent the second year, and so on.
Temporary buydowns don’t save you money – you pay upfront what you’d pay anyway over time. However, they can be paid for by your seller; in that case, you are saving money because the seller pays the upfront cost.
Temporary Buydowns and Qualifying
Although you might be paying a lower mortgage rate for the first few years of your loan, mortgage lenders still use the note rate when qualifying you for your mortgage. Unlike permanent buydowns, temporary buydowns don’t allow you to buy more house than you could otherwise.
FHA says in its underwriting guide:
While interest rate buydowns are permitted, the loan must be underwritten at the Note rate. Lenders may not underwrite at the buydown rate.
However, FHA does allow the existence of a buydown to be used as a compensating factor, which might offset other weakness in your application.
To actually qualify for as much house as possible, you’re probably better off choosing a hybrid ARM like a 5/1, which gets you a rate that’s about one percent lower than a comparable 30-year FRM, and buying the rate down permanently. For 5/1 ARMs, each discount point typically shaves about .375 percent off the rate. So, if the 30-year FRM rate is 3.54 percent, your 5/1 ARM rate is about 2.54 percent, and paying another two discount points could get you a rate under two percent for five years – and that’s the rate your lender would use to qualify you!
Both permanent and temporary buydowns have their places in the home loan market. However, if you're interested in either, remember that it's not just rates you have to compare; it's the complete mortgage deal.