What is a 2-1 buydown mortgage and how does it work?
In the past year, mortgage interest rates have skyrocketed to almost 7%—the highest in two decades, making it harder for would-be homeowners to buy property.
To mitigate the effects of inflation-driven rates and stabilize housing affordability, many opt for 2-1 buydown mortgages.
Read on to learn what this financing option is, whom it is best for, and how to get the most out of it.
What is a 2-1 buydown mortgage?
A 2-1 buydown mortgage is a loan financing option that offers a 2% lower interest rate in the first year and a 1% lower interest rate in the second year.
Only when the mortgage term enters its third year does the rate increase to the original term. But there is a caveat: In return for securing a two-year reduced interest rate, you pay a single fee known as a “point” during the home’s closing.
This fee is placed in an escrow account, from which a small amount is disbursed each month to offset the interest rate gap.
Sometimes sellers will propose covering a portion or even the entire upfront fee on your behalf to make the sale more attractive.
An example of a 2-1 buydown mortgage
Imagine you’re buying a $300,000 house with a 30-year fixed-rate mortgage at an interest rate of 5%. The seller offers to cover the one-time fee. In the first year, the interest rate would be 3%, resulting in a monthly payment of around $1,264.
In the second year, the rate increases to 4%, with a monthly payment of $1,423.
Then, in the third year and for the next 30 years, you’ll pay the full interest rate of 5%, resulting in a monthly payment of $1,610.
How to calculate buydown points
The buydown percentage is the amount by which the interest rate is lowered. In a 2-1 buydown, it’s 3%. To calculate the point fee, multiply the loan amount by the buydown percentage and divide it by 100.
For example,($300,000 x 3) / 100 = $9,000.
Therefore, you or the seller would be responsible for covering a portion or the entire $9,000 in buydown points at the closing to secure a 2-1 buydown mortgage. In essence, these points represent prepaid interest.
The downside of a 2-1 buydown mortgage
Just as with any financial arrangement, there are potential drawbacks to consider:
The up-fron tcost
2-1 buydown mortgages make the most sense when you plan to hold the property for a prolonged time or when the seller or builder covers a portion or the entirety of the initial fees.
Otherwise, you pay higher upfront costs compared to a traditional mortgage.
Market risks
A 2-1 buydown mortgage may cost more in interest than a standard fixed-rate mortgage, especially if you stay in the home beyond the initial buydown period and have a higher interest rate for most of the loan term.
Escrow problems
Escrow errors can occur due to changes in property tax rates, insurance premium adjustments, or poor account management. It’s crucial to regularly review escrow statements to avoid penalties or interest charges.
The upside of a 2-1 buydown mortgage
On the other hand, 2-1 buydowns open doors to homeownership that might otherwise have remained closed.
And, there are other benefits.
Save money
Increased disposable income each month can go toward reducing the principal mortgage (the original amount of money borrowed), funding home improvements, or other financial objectives.
Obtain a larger mortgage
A 2-1 buydown mortgage can help you get a bigger loan because it lowers your monthly payments in the beginning, improving your debt-to-income (DTI) ratio.
Short-term affordability
Lower initial payments are particularly helpful for first-time buyers because they allow for a smoother homeownership transition and provide short-term financial flexibility.
How 2-1 buydown mortgages are negotiated
Either you can request a seller’s concession, or the seller can proactively offer a 2-1 buydown mortgage. Remember that you still have to qualify for the full interest rate at the time of purchase.
Mortgages from government-sponsored mortgage companies Fannie Mae and Freddie Mac impose limits on 2-1 buydowns that depend on your down payment size.
For example, lower interest rate leniency is restricted to two years, and it can only go up one percentage point each year. So it can’t jump from 5% to 7%; it would have to increase from 5% to 6% before settling at 7%.
2-1 buydown qualifications
Qualifying for a 2-1 buydown is similar to other types of mortgages with a few specific considerations due to the unique features of this loan product.
- Credit score: lenders prefer a credit score of 620 or higher
- DTI: ideally, a DTI ratio between 28% to 48%
- Down payment: depending on the loan, this varies from 3% to 20% of the sales price of the property
- Upfront costs: be prepared to pay points and closing costs to secure the 2-1 buydown benefits
- Income verification: lenders assess pay stubs, W-2 forms, and tax returns to ensure you can repay the mortgage, even with adjusted interest rates
- Mortgage insurance: if your down payment is less than 20% of the home's purchase price, you will have to pay for private mortgage insurance (PMI)—a protection for the lender in case you default
Is a 2-1 buydown mortgage right for you?
Often, a seller will use a 2-1 mortgage offer to fast-track the sale of their home, especially if it's been on the market for a long time. As a buyer, there are three situations where a 2-1 buydown mortgage is useful:
- First, if your budget is tight, it can make home ownership more affordable in the early years
- Second, if you expect a significant income increase in the near future due to a promotion, career change, or are contemplating additional education, this mortgage offers a valuable two-year temporary relief until your earnings increase
- And third: if you have other financial objectives in mind, such as clearing high-interest debt, establishing an emergency fund, or making home improvements, you can achieve them by saving the money that would otherwise have gone toward the full interest rate
Leveraging a 2-1 buydown mortgage can make home ownership journey more affordable. To find the best loan, you should consult a trusted mortgage professional.