Pros and Cons of a 2-1 Buydown Mortgage

Getting into your first home can be challenging when mortgage rates are high. Temporary buydown mortgages like the 2-1 or 3-2-1 programs can relieve payment by lowering interest rates for the first few years. But they also come with risks.

A temporary buydown subsidizes the interest rate on your mortgage loan for an initial period, reducing your monthly payments. But once the buydown expires, your price will rise significantly. Understanding how buydowns work and weighing the pros and cons is crucial in determining if this approach suits your home-buying needs and budget.

In this comprehensive guide, we'll explain what temporary buydowns are, how 2-1 and 3-2-1 buydown structures work, eligibility requirements, pros and cons to consider, and alternatives to keep initial payments low while avoiding payment shock down the road.

What Is a Temporary Mortgage Buydown?

A temporary buydown is a program where the interest rate on your mortgage loan is lowered, or "bought down," for the first one to three years by applying subsidy funds. This reduces your monthly payments during the buydown period.

With a temporary buydown:

Your interest rate is discounted below the permanent market rate at closing.
You pay a lower rate for the initial 1-3 year period, reducing your payments.
Once the buydown expires, your interest rate rises to the permanent market rate in effect at closing.
Your payment jumps significantly to the fully indexed amount after the buydown term ends.

The home seller or builder typically provides the buydown funds to incentivize buyers during high-rate environments. Let's look at how 2-1 and 3-2-1 buydowns work.

How Does a 2-1 Temporary Buydown Work?

A 2-1 temporary buydown reduces your mortgage interest rate over the first two years.

Year 1: Your interest rate declines by 1-2 percentage points from the market rate. Your payment is much lower as a result.

Year 2: Your interest rate increases halfway back toward the original market rate, so your payment rises but remains below the fully indexed amount.

Year 3: The buydown ends, and your interest rate adjusts to the permanent market rate at the time of closing. Your payment jumps to the fully indexed amount.

For example, consider this 2-1 buydown scenario:

Permanent market rate at closing: 6%
2-1 Buydown rate Year 1: 4% (bought down 2 points)
2-1 Buydown rate Year 2: 5% (bought down 1 point)
Rate Year 3 onward: 6% (total permanent indexed rate)

Under this 2-1 structure, your payment in Years 1 and 2 would be significantly lower than the fully indexed payment at 6%. But in Year 3, when the buydown ends, your price would rise considerably to the 6% fully indexed amount.

How Does a 3-2-1 Temporary Buydown Work?

A 3-2-1 temporary buydown provides payment relief over three years.

Year 1: At closing, the interest rate is 3 points lower than the permanent market rate. This provides the most down payment.

Year 2: The interest rate is brought down 2 points below the market rate. Your payment rises from Year 1 but remains below the fully indexed amount.

Year 3: The rate is brought down 1 point below the original market rate. Your payment increases again but is still lower than a non-bought-down loan.

Year 4: The buydown ends, and the rate adjusts to the permanent indexed rate at closing—your payment spikes to the fully indexed amount.

Here is an example showing payments under a 3-2-1 buydown structure:

Permanent market rate at closing: 6%
Year 1: 3% (bought down 3 points)
Year 2: 4% (bought down 2 points
Year 3: 5% (bought down 1 point)
Year 4 onward: 6% (total permanent indexed rate)

As you can see, the 3-2-1 buydown further reduces payments in the first year but still produces sharply higher prices after the buydown expires.

Now, look at some key pros and cons of buydown mortgages for homebuyers.

Pros of Buydown Mortgages

There are some potential benefits of temporary buydowns to consider:

Lower payments for the first 1-3 years
It may allow qualifying for a more significant loan and a more expensive home.
Lock in lower rates on the permanent loan before rates potentially rise further.
Give yourself time for your income to grow and cover higher future payments potentially.
Provide payment flexibility at the start of homeownership.

By temporarily subsidizing payments, buydowns can help stretch your budget further when rates and prices are high. But there are notable drawbacks to weigh as well.

Cons of Buydown Mortgages

Disadvantages homebuyers need to watch out for include:

Require paying discount points upfront to the lender to receive the rate reduction.
Payments spike significantly upward once the buydown term expires.
Income may not rise enough over time to cover the payment jumps.
It can make it harder to refinance if payments become unaffordable after the buydown ends.
Risk overextending your budget by qualifying for the maximum payment possible under the temporary subsidy.
Feeling "trapped" if rising payments become unmanageable

While tempting, buydowns can lead buyers to overextend their budget and take on too much house. If your income fails to increase sufficiently to cover post-buydown payments, you can end up house-poor.

Buydown Eligibility and Requirements

For buyers to qualify for a temporary buydown, lenders typically impose eligibility requirements, including:

Meet all mortgage qualification and underwriting guidelines for the loan amount and permanent interest rate.
Have sufficient income to qualify for payments at the fully indexed rate without relying on the short-term subsidy.
Pay discount points upfront to the lender to receive the reduced interest rate.
Sign a buydown agreement outlining the annual declining subsidy and rising rates.

Lenders want to confirm that you can afford the mortgage payment once the temporary rate reduction expires. Sellers providing buydown funds also sign an agreement.

Should You Consider a Buydown Given Today's Rates?

With mortgage rates over 6% on a 30-year fixed loan, a temporary buydown to reduce payments may be appealing.

But the benefits are minimal if the permanent indexed rate and actual payment amount are still unaffordable for you when the buydown ends.

In that case, a buydown temporarily masks an unaffordable situation, leading to issues when payments spike but your income hasn't sufficiently risen.

Buydowns make more sense when the permanent rate is otherwise affordable for you, and the subsidy makes them even more attractive in the short term.

Alternatives to Temporary Buydowns

What alternatives do you consider for lowering your mortgage payment without relying on a temporary subsidy?

Opt for a less expensive purchase price to reduce your loan amount.
Make a larger down payment if possible; 20% down can reduce monthly payments.
Explore adjustable-rate mortgages, which offer lower initial rates but come with payment risk down the road.
Consider a 40-year mortgage term to lower payments but increase the total interest paid.
Improve your credit score to qualify for a lower rate to start with.

For many buyers, these options provide more significant payment relief than a small temporary buydown without the large payment spikes.

Conclusion

A buydown can enable stretching to buy more homes than otherwise possible. But if that more considerable payment amount still won't be affordable later based on your budget and realistic income growth, it's probably best to consider other options.

SOURCE:
https://singlefamily.fanniemae.com/job-aid/loan-delivery/topic/overview_of_temp_buydown.htm
https://migonline.com/loan_officer/jackiegonzalez/page/rate-buy-down
https://www.trinityoaksmortgage.com/assets/uploads/2018/10/2-1-Buydown-Web-Flyer.pdf