How does a Buydown work?

A buydown is a financial arrangement where a borrower pays an additional amount of money upfront to reduce the interest rate on a loan for a specific period. This is commonly used in the context of mortgage loans, but it can apply to other types of loans as well. The purpose of a buydown is to make the initial payments more affordable for the borrower.

There are different types of buydowns, but the most common ones include:

1. Temporary Buydown (or Interest Rate Buydown): In this type of buydown, the borrower pays an upfront fee to the lender or a third party, which is then used to subsidize the interest rate for a specified period. For example, a 2-1 buydown might lower the interest rate by 2% in the first year and 1% in the second year before reverting to the original rate from the third year onwards.
2. Permanent Buydown: With this type, the borrower pays additional upfront points to permanently reduce the interest rate over the entire term of the loan.
3. Down Payment Buydown: In some cases, a third party, such as a home builder or seller, may contribute funds to reduce the borrower's down payment, effectively acting as a buydown.

Here's a simplified example of how a temporary buydown works:

Let's say you have a 30-year fixed-rate mortgage with an interest rate of 5%, but you opt for a 2-1 buydown. In the first year, you might pay an interest rate of 3%, in the second year 4%, and from the third year onward, the rate returns to the original 5%.

The additional upfront payment made by the borrower is typically calculated based on the difference between the original interest rate and the reduced rate for each period. The specific terms of the buydown, including the duration and the amount of reduction, vary depending on the agreement between the borrower, lender, and any third party involved.

It's important for borrowers to carefully consider whether a buydown makes financial sense for their situation, taking into account the upfront costs and the long-term benefits.