BUY DOWNS – HOW THEY WORK
Having been suspended for some years, Buy Down loan options have been resurrected. During inflationary times accompanied by high interest rates and slower real estate sales periods, buy down loans can be useful for both buyers and sellers.
The goal of every real estate transaction should be to create a “win-win” situation for both buyer and seller. At the same time, it seems that everyone wants a “good deal”, too. An interest rate buy down can often be the vehicle to accomplish this win-win arrangement.
There are typically three primary ways that a seller can profit by offering a buy down to a buyer. 1.) It will “differentiate” the seller’s property within the market place and thereby “create an interest” to attract buyers. 2.) The buy down does not increase the buyer’s “ability to “qualify” for a loan . . . the buyer must qualify at the note rate . . . but it does incentivize the buyer to purchase as it can significantly save on the monthly payment. 3.) Finally, a buy down offer can often be less than a price reduction, the latter being too often the only method used to stimulate interest in the seller’s property. The buy down can actually “maximize the seller’s profit” by eliminating the need for any price reductions.
From the buyer’s perspective, a buy down will assist in his/her sense of being able to “afford” to purchase and is usually of greater benefit than a price reduction. Buy downs can be either “temporary” or “permanent”. The most common form of a temporary buy down is known as the 2/1 buy down. The buyer’s initial interest rate is reduced 2% below the normal start rate. For instance, if the current fixed rate is 6.0%, payments for the first year of the mortgage would be calculated at 4.0%, the second year payments at 5.0% and the third and subsequent years would be at the full 6.0% rate.
In the past, buyers were allowed to qualify at the first year bought down rate, thus assisting in qualifying perhaps for a larger loan amount. As this is the re-introduction of this loan vehicle, we will wait to see if changes occur to the qualifying component. But, presently, the buyer must qualify at the note rate.
A temporary buy down can benefit the buyer whose current income requires a “stretch” in the current payment but who anticipates that their income will increase during the next two years. The lower payments during the first two year period can help the buyer feel more comfortable now and feel able to make the increased payments as income grows. This can be a better alternative in meeting this initial affordability concern regarding the payment than the oft used option in the past of acquiring an adjustable rate mortgage.
Another alternative is the permanent buy down. In this situation, the interest rate is reduced for the entire life of the loan . . . for instance, if the current rate is 6%, the rate might be reduced to 5.5% for the full 30 year period. While the seller’s cost for each of these options is nearly the same, many buyers prefer the temporary buy down. Under most circumstances, the buyer is unlikely to remain in the home for a thirty year period plus the dollar amount of the savings is significant. Thus, the temporary buy down is typically a better arrangement.
A temporary buy down is financed “up-front” by placing funds into an account from which the lender subsidizes the monthly payments. Using the above mentioned scenario, if the loan is bought down from 6.0% to 4.0% for the first year and to 5.0% for the second year let’s calculate the amount necessary to affect the buy down on a $100,000 loan. We must calculate the difference in the payments between the 6.0% loan and the payments at 4.0% and then at 5.0% . . . This difference is the amount that must be deposited in an account at the close of escrow. In our example, the total amount would be approximately $2,221. (note; these figures are for a $100,000 loan amount. The buy-down amount for a $400,000 loan amount would be four times this amount) This can often still be less than a price reduction and approximate the amount of buyer assisted closing costs.
Obviously, in a brisk real estate market, sellers are not enthusiastic about providing this kind of incentive. With a more difficult to sell property or during slower market conditions, buy downs become more popular. While in the past the buyer could participate, the current buy-down option requires the seller to pay the fee. The buyer and/or lender cannot participate.
A buy down provision can be used with nearly all forms of financing but the transaction must be for the purchase of one’s single family residence. While a buy down may not be a desirable option in all cases, it can sometimes mean the difference in a buyer feeling able to purchase. And, it is an option to some of the other less desirable creative finance programs (i.e.; an adjustable rate mortgage) designed to promote a buyer’s ability to qualify.
Agent/Seller Caution: If home values begin to decline, the appraised value of the home could become an issue. For instance, if one over-evaluates a home’s value in order to accommodate the buy-down expense and the appraised value does not match or exceed the agreed upon sales price, a re-negotiation is likely. This could result in the seller not only providing a buy-down but also having to reduce the purchase price. A realistic original valuation of the property will be critical when acquiring the listing.