Temporary Buydown

A temporary buydown is an arrangement in which a party to a home purchase or refinance deposits funds into an account that pays part of the borrower's mortgage payment for a set period at the start of the loan, so the borrower pays as though the interest rate were lower. Fannie Mae, which calls it a "temporary interest rate buydown," allows the reduction on fixed-rate loans and certain adjustable-rate loans for a principal residence or second home, provided "the rate reduction does not exceed 3%, and the rate increase will not exceed 1% per year," over a buydown period of no more than three years.

The word "temporary" is what separates it from the other kind of buydown. Paying discount points at closing buys a permanently lower rate on the note itself. A temporary buydown leaves the note rate untouched; as Fannie Mae puts it, "In no event may the buydown plan change the terms of the mortgage note."

The note is the real loan. Fannie Mae requires that "the mortgage instruments must reflect the permanent payment terms rather than the terms of the buydown plan." The buydown lives in a separate written agreement between whoever provides the funds and the borrower, and the money sits in a custodial account that must be fully funded before Fannie Mae buys the loan. The borrower's "only interest in buydown funds is to have them applied toward payments as they come due under the note." If the funds are ever unavailable, the agreement must say the borrower is "not relieved of the obligation to make the mortgage payments required by the terms of the mortgage note."

Qualifying at the full rate. "When underwriting loans that have a temporary interest rate buydown, the lender must qualify the borrower based on the note rate without consideration of the bought-down rate." That rule is the most important thing to understand about the product. A buydown makes the first years cheaper, but the lender has already confirmed that the household can carry the full payment, so the buydown is a cash-flow cushion rather than a way to afford a bigger house. A borrower who chooses a larger loan because the year-one payment looks manageable is taking the risk the qualification rule was written to prevent.

Who pays, and the limits that follow. A seller or home builder may offer a buydown as a sales incentive, and a lender can fund one too. When the money comes from an interested party (the seller, the builder or developer, or a real estate agent or broker), Fannie Mae counts "the cost of that subsidy" in its limits on interested-party contributions. Those limits are a percentage of the lower of the sales price or appraised value: for a principal residence or second home, 3% where the loan-to-value ratio is above 90%, 6% from 75.01% to 90%, and 9% at 75% or less. Other closing costs the seller pays come out of the same allowance, apart from the fees a seller customarily pays under local custom, which Fannie Mae leaves outside the limit, and a concession above the limit is treated as reducing the sales price. Fannie Mae does not allow temporary buydowns on investment properties or cash-out refinances.

Early payoff, sale or foreclosure. Buydown funds "are not refundable unless the mortgage is paid off before all the funds have been applied." On a payoff, Fannie Mae's rule is that the unused funds are credited to the payoff amount or returned to the borrower or the lender, as the buydown agreement specifies; on a foreclosure they reduce the mortgage debt; and if a buyer assumes the loan, the subsidy can continue on its original schedule. So a borrower who refinances in year one generally does not lose the unused balance, but where it goes depends on the agreement's wording.

Temporary buydown or permanent points? Money spent on a temporary buydown produces a known saving over one to three years and nothing after. The same money spent on discount points lowers the rate for as long as the loan is kept, at a price the lender quotes. Which is worth more depends on how long the borrower expects to keep the loan and on whether rates fall enough to make an early refinance likely; a borrower who refinances within a couple of years gets the full value of a temporary buydown and only part of the value of points. These are Fannie Mae's rules for loans it buys; FHA, VA and other programs set their own.

The cost of a temporary buydown is the total of the payment reductions it promises, deposited up front. The borrower pays the reduced amount each month, and the servicer draws the difference from the buydown account.

Consider an example. Beatriz borrows $400,000 on a 30-year fixed-rate mortgage with a 6.5% note rate, and the seller funds a 2-1 buydown. Assuming the plan sets each year's payment at what the loan would carry at the reduced rate, the monthly principal-and-interest payments are $2,528.27 at 6.5%, $2,271.16 at 5.5% and $2,026.74 at 4.5%. In year one Beatriz pays $2,026.74 and the account covers $501.53 a month, or $6,018.36 for the year. In year two she pays $2,271.16 and the account covers $257.11 a month, or $3,085.32. From year three she pays the full $2,528.27. The seller's deposit is therefore $6,018.36 + $3,085.32 = $9,103.68, about 2.3% of the loan. On a $500,000 purchase with 20% down, and a home that appraises at the price, the loan-to-value ratio is 80%, so the seller's contributions to Beatriz's costs are capped at 6% of $500,000, or $30,000, under Fannie Mae's rules, and the buydown uses $9,103.68 of that allowance. The lender still had to confirm she could afford $2,528.27 a month before approving the loan.

Pros

• Lowers payments in the first years, which can help while moving costs, furnishing or a second income are still settling.
• Often paid by a seller or builder, so the benefit can come at no direct cost to the buyer.
• The note rate is unchanged, so there is no adjustable-rate risk created by the buydown itself.
• Unused funds are generally not forfeited on an early payoff; they are credited or returned under the agreement.

Cons

• The saving ends after one to three years, and the payment steps up to the full amount on a fixed schedule.
• On a loan Fannie Mae buys, it does not increase what you can borrow, because the lender qualifies you at the note rate.
• A seller's buydown uses part of the same interested-party allowance that could otherwise pay closing costs, and a seller may price it into the sale.
• The same money spent on discount points would lower the rate for the life of the loan, which can be worth more to a borrower who keeps the loan long.