When you decide to do so buying a houseyou are not only responsible for paying the purchase price of the home but also the mortgage interest rate – the cost of borrowing money from your mortgage lender.
While Interest rates have fallen in recent monthsMany home buyers are still looking for ways to make home buying more affordable. And while it may be tempting to sit tight and hope that mortgage rates will continue to drop, that’s not guaranteed to happen. This is where the purchase of the loan amount begins.
By paying less up front, you can guarantee a lower price mortgage rate and keep more money in your pocket every month.
What is a mortgage purchase?
A “mortgage buydown” is a financial agreement in which the buyer, seller, or builder pays. housing pointsalso known as discount points, when closing to get a lower interest rate. This one-time payment is paid at the closing of the exchange at a low interest rate.
There are many ways to buy a loan, depending on your lender and whether you are looking for a permanent or short term loan.
Permanent versus short-term purchases
A mortgage purchase may take place during a fixed period or the duration of the loan.
Buying down a permanent mortgage
With this option, you will purchase a lower rate for the entire term of the loan when you close from your lender with discount points. Unlike a short-term asset purchase, the rate will never go up.
Purchase of temporary assets
With this program, the interest rates on the loan will be reduced for a period of time before returning to the normal rate. You’ll see short-term purchase structures called “3-2-1 buy-downs” or “2-1 buy-downs,” for example. We’ll cover what each setting looks like later.
How much does it cost to buy a mortgage?
Each loan point you pay the borrower is typically equal to 1% of the loan amount and typically reduces your interest rate by 0.25%. For example, one point can reduce the mortgage rate from 6% to 5.75%. However, the amount of each discount point that lowers the rate can vary between lenders.
An example of buying real estate
Let’s say a mortgage lender offers you, the borrower, the ability to reduce interest by 0.25% to buy one point. So, if your loan amount is $500,000 and the interest rate is 6%, the borrower can lower his interest rate to 5.75% with one discount point by paying $5,000 (1% of $500,000) upfront.
When should you consider buying down your mortgage?
Buying a mortgage can be a smart strategy if your goal is to lower your monthly payment, especially in a high-quality area. But it is not suitable for every consumer. Whether a down payment makes sense depends on who is paying you, how long you plan to stay in the home, and whether you want short-term or long-term payment relief.
Buying a mortgage makes the most sense if:
The seller or builder pays for it.
This is a very attractive situation for buyers. In a buyer’s market, sellers and home builders often offer lower purchase prices as a concession to help move inventory. Since you get the benefit of a lower interest rate without paying the cost yourself, this is usually a win.
You want a lower payment for the first few years.
Many buyers use a short-term purchase, such as a 2-1 or 3-2-1 purchase, to ease into home ownership. This can be helpful if your income is expected to increase, you are adjusting to the cost of a new home, or you are looking for extra money for moving and home improvements.
Plan to stay at home long enough to allow for upfront costs.
If you’re paying for the purchase yourself, it usually only makes sense if you plan to stay in the home long enough for your monthly savings to offset the cost of the discount points.
You buy when interest rates are relatively high.
Buydowns are most popular when mortgage rates are elevated and buyers are looking for ways to improve affordability without waiting for rates to drop.
When buying a mortgage may not work well
A purchase may not make sense if:
- You’re short on cash after covering your down payment and closing costs
- Plan to sell or refinance in the near future
- You would like to use that money to increase your payment
In some cases, putting more money toward your down payment or keeping it in savings may provide more flexibility than locking in discount points.
Types of mortgages
There are three common arrangements for buying short-term assets: “3-2-1 short”, “2-1 short”, and “1-0 short.” Find out how each of these options works below:
What is 3-2-1 shopping?
A 3-2-1 purchase allows the borrower to pay a lower interest rate for the first three years of the loan. In the first year, the interest rate is three percent below the current rate, increasing by one percentage point each year for the next two years. In the fourth year, the rate will be the same as the amount you locked in at the beginning of your mortgage.
Review the chart below to see how purchasing a 3-2-1 home can affect the monthly mortgage payment for a buyer on a $400,000 30-year loan with 6% interest.
| A year | Interest Rate | Monthly payment | Monthly Savings | Annual Savings |
|---|---|---|---|---|
| 1 | 3% | $1,686 | $712 | $8,544 |
| 2 | 4% | $1,910 | $488 | $5,856 |
| 3 | 5% | $2,147 | $251 | $3,012 |
| 4-30 | 6% | $2,398 | $0 | $0 |
The number of mortgage points charged for a down payment will vary from borrower to borrower. However, you will find that the cost of the purchase is usually equal to the amount the buyer will save in interest. Using the example above, the mortgage purchase cost about $17,412.
What is a 2-1 purchase?
The purchase of a 2-1 home is similar to a 3-2-1 property, except that the down payment is for the first two years of the loan term. This will give the buyer an interest rate 2% lower than the normal rate in the first year and 1% lower in the second year.
Using the same example above, taking out a $400,000 30-year mortgage with a typical interest rate of 6%, let’s look at how a 2-1 purchase can play out.
| A year | Interest Rate | Monthly payment | Monthly Savings | Annual Savings |
|---|---|---|---|---|
| 1 | 4% | $1,910 | $488 | $5,856 |
| 2 | 5% | $2,147 | $251 | $3,012 |
| 3-30 | 6% | $2,398 | $0 | $0 |
In the first two years of the loan term, the buyer will save approximately $8,868 in interest. Knowing this, we can expect the cost of buying 2-1 to be the same.
What is a 1-0 purchase?
Buying 1-0 is a 1% reduction in interest rates in just the first year. Check out the chart below to see how this structure works out over a 30-year loan of $400,000.
| A year | Interest Rate | Monthly payment | Monthly Savings | Annual Savings |
|---|---|---|---|---|
| 1 | 5% | $2,147 | $251 | $3,012 |
| 2-30 | 6% | $2,398 | $0 | $0 |
Use a monthly mortgage calculator with a monthly payment rate at various interest rates.
The pros and cons of buying a mortgage
Under the right circumstances, foreclosures can be a great option for both home buyers and sellers. Understanding your situation and being aware of the costs involved can help you avoid some of the potential pitfalls.
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Who pays for a mortgage buydown?
Although the buyer will ultimately benefit from the mortgage purchase, sellers and builders may also choose to purchase discount points to lower the buyer’s interest rate.
Pay the expenses yourself
A mortgage purchase is usually negotiated between the buyer and their lender. If you have extra cash after budgeting for your down payment, you can use this money to buy a mortgage advance for lower interest rates.
Ask the seller to pay
If a seller needs to sell their home quickly or is selling for buyer’s marketthey may ask to pay off the loan amount as an incentive to buy their home. If so, the seller will make a one-time deposit on it escrow or pay points on the entire loan as part of the seller permissionor closing costs that the seller has agreed to pay. This money provides the mortgage lender with funds to lower the buyer’s interest rate so that they can pay off the home more easily. However, the seller may try to offset the cost of the mortgage with the purchase price of the home to cover the cost.
Use the builder’s closing cost incentives
Home builders may offer financial incentives to purchase their newly constructed properties. You can use the funds to cover closing costs, including your purchase price.
Use gift money
If a family member or close friend has given you money, you can use this money to purchase the loan amount. However, there are limits to the amount you can receive as a gift without receiving a gift tax.
Frequently Asked Questions about buying a home
What are the other ways to buy real estate?
Adjustable-rate mortgages (ARM) again refinancing are possible options for those who want to save on their mortgage payment.
Remember that both are subject to market rate volatility. Refinancing is only important if interest rates go down, while an ARM can leave you in the running for a higher payment if rates go up.
What are some ways to lower my interest rate?
If you’d like to lower your interest costs without paying more upfront, you can start by taking steps to increase your credit score. A higher score can get you a lower interest rate on your loan, lowering your monthly payment.
Contact your mortgage lender
Make sure you work with yourself mortgage lender to find you the best loan arrangement, or if a mortgage makes sense at all for your situation.
Redfin does not provide legal, tax, or financial advice. This article is for informational purposes only and is not a substitute for professional advice from a licensed attorney, tax professional, or financial advisor.
