Buydown – Definition

Cite this article as:"Buydown – Definition," in The Business Professor, updated July 30, 2019, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/buydown-definition/.

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Buydown (Mortgage) Definition

A buydown refers to a technique used for mortgage financing in which the buyer tries to receive a lesser interest rate for the whole mortgage life. If not the entire life, he/she seeks to receive it at least in the initial stage. For the purpose of reducing the interest rate per month, as well as the monthly payment, the one who sells the property offers payments to the financial institution lending mortgage. In order to balance out the costs associated with the buydown agreement, the builder or the seller generally raises the purchase price of the property.

A Little More on What is a Buydown

Buydown is a subsidy that a home buyer receives on seller’s behalf. The person selling the property keeps adding funds to an escrow protection account every month in order to get a subsidized mortgage (for at least the beginning years). This cuts down on the payments made every month, which ultimately makes it easier for home buyers to be eligible for the mortgage.. Be it property sellers or builders, both may provide  a buydown option so as to make the property more obtainable for its buyers.

Buydown Structuring

There are different ways and methods to outline buydown terms for mortgage loans. Most of the buydowns function for some years. After the buydown agreement is over, the payments for mortgage rise and are set at market rate. A couple of basic structures for mortgage buydowns include 3-2-1 and 2-1.

3-2-1 Buydown

For the 3-2-1 mortgage buydown, the purchaser pays less on the mortgage for a period of three years. The amounts for buydown contributed by the seller balance out these payments. For instance, the home buyer who takes a loan of $150,000 for a period of 30 years with a fixed rate of interest of 6.75% will pay less in the first three years. For the first year, they would pay 3.75%; for the second year, the rate of interest would increase to 4.75% and for the third year, it would be 5.75%. After these three years, the standard rate of interest will be 6.75% and for the remaining years, they will be paying the amount of $973 per month. In the first three years, they will be able to save from lower rates of interest. And whatever difference be in those payments would be borne by the property seller. He/she will make this payment to the lending institution in the form of a subsidy.

2-1 Buydown

A 2-1 buydown follows the same approach as 3-2-1, with the only difference being the lower interest rate is available for the first 2 years instead of 3. For instance, if Mr. X borrows $100,000 for a tenure of 30 years, and the fixed rate of interest is 6.75%, he can reduce his mortgage payment for the first 2 years. They would pay 4.75% in the first year, and 5.75% in the second year. And after 2 years, they’ll be paying $649 per month at a standard rate of interest of 6.75%. The seller will balance the amount of money saved in the first 2 years by making subsidy payments to the lending institution.

Reference for “Buydown”

Academic Research

Capture technology cost buydown in CO2 EOR market applications under an Alternative Energy Portfolio Standard, Williams, R. H. (2014). Energy Procedia, 63, 7913-7928. Although CO2 capture and storage (CCS) as a major carbon-mitigation option is key to the affordability of a low- carbon energy future and substantial progress that has been made in advancing CCS, what has been accomplished falls far short of what is needed to enable a low-carbon energy future. Here a strategy is outlined aimed at helping get the faltering global CCS enterprise back on track. It involves: (a) exploiting the US CO2 enhanced oil recovery (CO2 EOR) opportunity to help buy-down costs of promising CO2 capture technologies via experience (learning by doing) and (b) enacting an Alternative Energy Portfolio Standard (AEPS) as a policy instrument to promote this CO2EOR activity in coal-dependent states or regions. Alternative power-only options based on coal and natural gas as well as options coproducing liquid transportation fuels and electricity based on coal and coal/biomass are considered as candidates for technology cost buydown (TCB) under the AEPS, and impacts of the TCB on electricity prices are estimated for the most promising technologies.

Benefit-cost analysis and optimization modeling for a seller/builder buydown mortgage, Carswell, A. T., & Babiarz, P. (2016). Journal of Real Estate Practice and Education, 19(1), 87-97.

Discount point concessions and the value of homes with conventional versus nonconventional mortgage financing, Asabere, P. K., & Hoffman, F. E. (1997). The Journal of Real Estate Finance and Economics, 15(3), 261-270. This is an empirical investigation on the impacts of certain seller concessions on home prices. Specifically, we examine the impacts of two seller concessions: discount point concessions (DPCs) and closing cost concessions (CCCs) on home prices. Using hedonic analysis, we find that DPCs are capitalized into home prices. We do not find that CCCs produce capitalization effects. DPCs appear to work in a manner similar to other creative financing techniques such as a buydown mortgage. DPCs enhance affordability by lowering interest costs and debt service payments. DPCs thus lead to increases in effective demand. CCCs will reduce out of pocket expenses but will not necessarily enhance long-term affordability, thus their price effects are less certain. We show that these price premiums are prevalent only when conventional mortgage financing is used. When FHA and VA loans are used, premiums disappear. Of course, governmental insured/guaranteed loans are much more subject to regulation than conventional loans, which may prevent homesellers from price premium maximization. The study establishes the relative significance of discount points versus closing costs as marketing incentives. It appears that the use of discount points as a marketing incentive produces more capitalization effects. The presence of such capitalization effects is consistent with results found in other creative financing studies.

Mortgage Rate Buydowns: Implications for Housing Price Indexes, AGARWAL, V. B., & PHILLIPS, R. A. (1984).  Social Science Quarterly, 65(3), 868.

Mortgage Rate Buydowns: Further Evidence, Agarwal, V. B., & Phillips, R. A. (1984).  Housing Fin. Rev., 3, 191.

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