The good news is, you’ve got the money for a down payment. That’s not a problem. What you’re more worried about is keeping your mortgage payments low, so you still have enough cash flow each month to eat out, buy the things you want and cover your annual vacation to St. Croix.
Besides increasing the size of your down payment to lower your monthly mortgage, you can also take out a permanent buydown mortgage, also known as “buying down the rate.”
Buydowns involve “discount points.” These are fees paid to your lender at closing in exchange for a reduced interest rate. A point is equal to 1 percent of your mortgage amount (or $1,000 for every $100,000). With a lower rate, of course, your monthly mortgage payments will be lower over the life of your loan.
There are three ways to purchase points. You can buy them yourself, look for a builder to buy them or you can ask he seller of an existing home to purchase them for you.
Let’s look at all three options more closely:
Buying down the loan yourself
This is by far the most common scenario. You are only paying some interest (in the form of discount points) up front to lower your subsequent mortgage payments. As a rule, the longer you plan to own your home, the more you might benefit from buying points because you would realize more interest savings over the life of your loan.
Let’s say, you want to borrow $200,000 at 5.125 percent. Without figuring for taxes and insurance, your payment would be $1,088. If you purchase a point for $2,000 (1 percent of $200,000), you would lower your rate a quarter point (.25) to 4.875%, reducing your monthly payment to $1,058, saving you $30 each month.
To recover that $2,000 buydown, you would have to own your home for 65.4 months. To calculate this “break-even” point, you divide $2,000 (your upfront cost) by $30 (your monthly savings). So, if you plan on living in your home for longer than about five and a half years, you’ll come out ahead.
A couple of words of caution: Different lenders will often different buydown rates. In our example, the lender lowered the rate a quarter of a percent (.25) per the purchase of one discount point. Some lenders might only reduce the interest rate an eighth of a percent (.125) for the purchase of one discount point. So, if you’re shopping for discount points, ask each lender what the buydown rate is.
Getting a builder or developer to help
Builders and developers often use the buydown to incentivize and induce buyers to pull the trigger on a new-home purchase. They offer what is known as a 3-2-1 buydown. This is a twist on the permanent mortgage buy down. It’s a temporary buydown, meaning the participating builder will reduce your monthly payment, typically on a 30-year-fixed-rate mortgage (principal and interest) by 3 percentage points below the market rate the first year of your loan, two percentage points the second year of your loan and 1 percentage point the third year of your loan. From the fourth year forward, you will pay your true, unassisted rate.
So, in a 3-2-1, if you took out a $100,000 loan at 7 percent, the builder would knock down your first-year start rate to four percent for a monthly payment of $477. The second year, your rate would rise to 5 percent ($564) and the third year, it would climb to six percent ($600). In years four through 30, your monthly payment would be $665.
At five percent, your $100,000 loan would result in monthly $536 payments, but with the 3-2-1 buydown, your monthly payments would be $370 the first year, $422 the second year, and $477 the third or final year of your buydown.
While the borrower’s payments are reduced in the early years in the 3-2-1 buydown, the payments received by the lender are the same as they would have been without the buydown. The shortfalls from the borrower are offset by withdrawals from an escrow account that the builder has funded.
Asking the home seller for help
Let’s say, the home seller received an offer $50,000 below his asking price might, but is still motivated to sell his house. (This motivation increases in a slowing market.) Rather than just nixing the deal, the seller could offer the buyer a permanent buydown mortgage.
Why on earth would the seller ever do that? Here’s the logic:
By agreeing to pay a certain amount of money upfront to the buyer’s lender, the seller can reduce the buyer’s monthly payment to a more manageable monthly level. With the savings, but the buyer could realistically raise his or her offer.
Let’s say, that it costs the seller $1,000 to buy down the loan 1/8th of one percent. Thus, it would cost the seller, $8,000 to buy down the interest rate a full 1 percent or $16,000 to buy down the buyer’s loan a full 2 percent.
For the buyer, the difference between paying 5 percent and 4 percent over 30 years would result in savings of $21,384. The difference between paying 5 percent and 3 percent over 30 years would result in savings of $41,479.
So, if the seller agrees to kick in $16,000, the buyer should be able to bring up her offer more than $40,000. The point is, introducing a buydown strategy can bring two parties closer together or at least within shouting (negotiating) range. For more help with calculations, use the MyBankTracker mortgage calculator.
Buydowns offer great solutions to help you keep your mortgage payments manageable. You can undertake this strategy yourself or lean on builders and sellers for their buy-ins to help you reduce your monthly mortgage.
The bottom line is, if you want to buy a house and still have the cash flow to maintain your current lifestyle, you have options.
Peter is a staff writer at MyBankTracker.com who covers banking, personal finance, investing and homeownership.