What is a temporary buydown and how does it work?

Reader question. “We were talking to a mortgage broker via email and one thing he suggested was a 3-2-1 temporary mortgage rate buy down to help us obtain a lower interest rate. This term is not something I am familiar with. Before I return to him, I need to learn more about this term. Could you please explain in plain English how a 3-2-1 buydown works?

This subject can be complicated, so I will do my best to make it easy for you. You are doing the right thing by asking questions. This is one of the most important qualities a mortgage shopper could have. This is a great achievement!

Definition of the 3-2-1 Temporary buydown

By paying more cash upfront during closing, a mortgage buydown can reduce the interest rate of your loan. It’s basically a way to lower the long-term cost of your loan by paying more money at closing. But don’t be too worried about the extra cost.  You can ask the seller to cover this buydown for you in some cases.  It can definitely be a better option than reducing the sales price.  I can prepare an exact cost analysis for you once you have a house in mind.

There are two types: temporary and permanent. They are very similar.

• Temporary buydown — This strategy lets you reduce your mortgage rate temporarily. This category includes the 3-2-1 buydown, the 2-1 buydown, and the 1-1 buydown, which generally works over a period of three years, 2 or 1 year respectively.
• Permanent buydown – This is when the rate of your loan is reduced over its entire term. This is the best option in a long-term financing contract.  If you plan on moving or refinancing with in a short period of time, I wouldn’t suggest this.

This is how the 3-2-1 mortgage buydown works. To reduce the interest rate for the first three years, you pay a set amount at closing. The permanent rate will be 3% lower for the first year. It will be 2% lower than the note rate for the second year. It will also be 1% lower than the note rate for the third year.

Here’s an example.

Let’s suppose I apply for a mortgage loan and the lender says I am eligible for a 7.75% rate of interest based on my credit rating and other factors. Due to renovations I have to make to the house, I expect to incur additional costs in my first year. So, I would like to lower my mortgage payments in the first few years.

To achieve my short-term savings goal, I could use a 3-2-1 interim mortgage buydown. This would mean that I would have to pay a little more for my closing costs, or ask the seller to pay this for me. This would allow me to reduce my interest rate and, consequently, my monthly payments during years 1 through 3.

• 4.75% interest for the first year (7.75% less by 3).
• 5.75% interest in the second year (7.75% less by 2).
• 4.75% interest in the third year (7.75% less by 1).
• For the remaining term of the loan, 7.75% interest

In other words, the rate is being reduced by 3 percentage points in the first year (from 7.75% down to 4.75%). 2% for the second and 1% for the last year. Does that make sense?

The interest rate will return to the number that the lender had assigned at the time of the initial application and approval. In my case, it was 7.75% interest. The key is to ensure that you are not paying more to lower the rate than you will save over the first three years.