A 2-1 buydown is a specialized mortgage agreement that offers homeowners a lower interest rate for the first year, a slightly higher rate for the second year, and then moves to the full rate in the third and subsequent years. This financing technique can make homeownership more accessible and attractive, especially in the initial stages.
Key Highlights
- Reduced Initial Rates: A 2-1 buydown begins with an interest rate that’s typically two percentage points lower in the first year, increases by one percentage point in the second year, and reaches the full permanent rate in the third year.
- Incentive for Buyers: Sellers, including home builders, often offer 2-1 buydowns to entice potential buyers by making their properties more affordable up front.
- Risk and Reward: While a 2-1 buydown offers lower payments initially, homeowners must be prepared for higher principal payments in subsequent years.
How a 2-1 Buydown Works
A buydown reduces the initial interest rates on a mortgage, either temporarily or permanently, by making an upfront payment to the lender. The 2-1 buydown falls into the temporary buydown category, easing the financial burden for homebuyers for the first two years of the loan.
Typically, in a 2-1 buydown, the interest rate:
- Is reduced by two percentage points in the first year
- Increases by one point in the second year
- Transitions to the full rate from the third year onward
To compensate for lost interest, lenders may charge an added fee. Payments for this buydown can be made by either the homebuyer or home seller and may come in the form of mortgage points or a lump sum placed into an escrow account.
Practical Example: 2-1 Buydown Mortgage
Imagine a real estate developer offers a 2-1 buydown. With a prevailing 30-year mortgage interest rate of 5%, the homebuyer enjoys a rate of 3% in the first year, 4% in the second year, and 5% thereafter.
For a $200,000 mortgage, monthly payments would look like this:
- First Year: $843
- Second Year: $995
- Third Year and beyond: $1,074
Weighing the Pros and Cons
For Home Sellers:
- Pros: Fastens the selling process by attracting more buyers.
- Cons: Reduces net profit due to the added buydown cost.
For Homebuyers:
- Pros: Opportunities for affording a larger mortgage and a more expensive home. Allows time for income to potentially increase before higher payments kick in.
- Cons: Risk of income not keeping pace with rising mortgage payments, leading to financial strain.
Strategic Use of a 2-1 Buydown
Home sellers finding it difficult to sell might consider offering (and financing) a 2-1 buydown as a valuable incentive.
On the other side, homebuyers could benefit from a 2-1 buydown to manage initial payment requirements, but they should plan for future years when the payments increase.
Notably, buyers should ensure that the initial home price is fair and not inflated by the seller to cover the buydown cost.
Important Considerations
- Not all states or federal mortgage programs offer 2-1 buydowns.
- Fixed-rate Federal Housing Administration (FHA) loans allow 2-1 buydowns, but this option is not available for refinancing.
- Terms and availability can vary by lender.
Related Terms: fixed-rate mortgage, refinancing, mortgage points.
References
- U.S. Department of Housing and Urban Development. “Section A. Special Underwriting Instructions”, Page 6-A-8.
