2-1 Buy Down Breakdown- How they work and when they make Sense
I am sure by now you have received 50-100 emails about lenders offering 2-1 buy downs. I wanted to take a minute to explain exactly how they work and when it makes sense to use them.
First, let’s make sure we identify the difference between a 2-1 buy down and buying down the rate. Buying down the rate is where you pay money at closing to get a lower interest rate for the life of the loan, also known as “paying points.” 1 “point” (or 1 percent of the loan amount) in cost upfront improves the rate by .25% for 30 years. The break-even is typically 5 years and 5 months. Want to take a guess on what the average lifespan of a mortgage is?? Yup, 5 years and 5 months. Think of interest rates like a menu. Each rate has a cost associated with it. The lower the rate the more money it costs. The most commonly locked-in interest rate up until this year was a rate with “0 pts” or what is often called “par” rate.
Earlier this year I wrote about why its difficult to find a “par rate.” As rates started rising a common solution that we as lenders had to come up with was, well, see if the seller will contribute money towards closing costs so the buyer can “buy down the rate” to the rates of the good old days. This concept was suggested just a few months ago. As rates continued to climb this concept should probably be replaced with the 2-1 buy down.
In a 2-1 buy down, let’s say the 30-year fixed rate is 7%. In the 1st year, the rate will start out at 5%. It will go to 6% in year 2, and finally cap out at 7% in year 3 for the remaining 28 years of the mortgage. The cost to participate in this program is simply the savings over the first 2 years due at closing. Let’s say it’s a $400,000 loan amount, the P and I in year 1 at 5% would be $1909. In year 2, at 6% the P and I would be $2398 and finally year 3 at 7% the P and I would be $2661. The savings between year 3 and year 1 is $514 a month x 12 months = $6,168. The savings in year 2 would be $263 per month x 12 = $3156. The total savings over 2 years would be $9,324 and that is what would be due at closing. This only makes sense if the buyer is definitively going to be making more money in the upcoming year, as an example let’s say it’s a doctor finishing up residency, OR the seller is paying for the cost of the buy down. Otherwise, there is no financial advantage to pre-paying the money you will save over 2 years.
That said, if you compare a $9,000 seller incentive whether it’s reducing the price $9,000 or contributing $9,000 to buy down the rate permanently, the 2-1 buy down certainly goes much further from an affordability standpoint. Lowering the price $9,000 would only lower the payment $57 per month. Using $9,000 to permanently buy down the rate from say 7% to 6.25% would save $200 per month for the life of the loan. If the buyer ends up refinancing in say 2 years, $200 per month savings over 24 months would be $4800 of the $9,000 incentive from the seller. The other $5,200 will have been wasted essentially. There are no guarantees that the buyer will refinance in 2 years, and if the buyer stays in the mortgage for 4 years or more than buying down the rate permanently would be the better option. Let’s look at it another way. Let’s say the buyer refinances in 12 months. In the 2-1 buy down the buyer would have essentially utilized $6,000 of the $9,000 incentive, because most of the monthly savings occurred in the first year. However, in the example of the permanently bought down rate, the buyer would have only saved $2400 and wasted the remaining $7,600 incentive.
If this were 4 months ago, where rates were in high 4’s or low 5’s, my advice would have been to permanently buy down the rate into mid 4’s because the likelihood of that loan lasting the time it would take to recoup the upfront cost would have been more likely.
Living in Vegas, we learn to play the odds, and odds are rates will come down in the next 1-2 years and anyone buying or have bought a home in the past 8 months will end up refinancing. My advice is that that a 2-1 buy down would be better way to spend a seller contribution than buying down the rate.