VA Rate Buydowns Explained
Should I buy down my interest rate or lock a rate without a buydown cost and just refinance later? Should I buy down now and still plan to refinance later? Should I do a temporary buydown or a permanent buydown – or both? What is an interest rate buydown anyhow? Let’s dig in.
What is an interest rate buydown?
An interest rate buydown is a mortgage option that gives you, the borrower, a lower interest rate in exchange for paying more money upfront at the time of closing. Buydowns can be temporary or permanent. We’ll start with the permanent kind.
“Discount points”, or just “points”, are what you pay to permanently buy down your interest rate. One point is 1% of your loan amount and that does not change. It is a one-time cost. If you don’t buy down your rate, then you will either have a “par rate”, which is the current rate with no points, or a “premium rate”, which is a rate above the par rate that comes with a lender credit.
How much will a rate buydown reduce my rate?
Even though one point is always a 1% cost of your loan amount, how much it affects your rate changes frequently, even daily. Sometimes paying a full point will reduce your interest rate by 0.25. Other times, it may reduce your interest rate by as much as 0.75, or somewhere in between. So, paying one point may take you from a 7.00% rate down to 6.75%, or it may get you to 6.50%, or 6.25%, or perhaps even lower. The cost fluctuates over time with the bond market. Also, buydown costs are not exact. Many times, your lender will give you buydown options that are more or less than one point. You typically have partial point options above and below 1%. Most lenders have buydown options available up to 5 points, sometimes more.
How much money can a rate buydown save me?
Here’s an example. If you are buying a $500K home and you have $10K to work with, whether it is money from the seller or cash in your bank account, you have several options to consider. (Assuming normal closing costs, escrows, etc. are already accounted for.) Applying that $10K to your VA loan as a down payment, making it a $490K loan, will reduce your money payment by roughly $67 per month at a 7.00% interest rate. Now, let’s say instead of using the $10K for a down payment you use it to buy down the interest rate to 6.00%. That buydown, in this example, will reduce your monthly payment by roughly $329 per month. So, that is an additional $262 per month savings for the life of the loan compared to putting that money down as a down payment.
How do I determine if this makes sense for me financially?
First off, you need to have the funds available, whether those funds are coming from your pocket, or the seller’s. If those funds are coming from you, then you need to consider alternate uses of those funds, such as paying off other debts or leaving those funds where they are if they are well-invested or perhaps needed for future needs.
Those considerations aside, it is a matter of calculating the “time to recoup” to determine your “break-even” number for the number of months for the monthly savings to be worth the upfront cost. The scenario above has a calculated time to recoup of under 31 months. That means, after 31 payments, you will have completely recouped the initial $10K you spent to buy down the rate to 6.00%. Then you will continue to enjoy the $329 per month savings from the lower interest rate for the entire remaining term of your loan. Of course, if you think it is likely that you will sell your property in less than 31 months, then you would not want to use that particular rate buydown because you would not fully recover the cost.
Can’t I just take the “par rate” now and refinance to a lower rate later?
Sure, that’s certainly an option to consider, especially since the VA has a great streamline refinance program. However, this assumes rates will be lower in the future AND drop low enough to warrant a refinance. We would all like to think that is what is going to happen, but it’s certainly not guaranteed. By doing the permanent rate buydown now, you lock in that lower rate for the life of your loan, and you still have the option to refinance in the future if rates drop enough to justify the cost.
What is the difference between a “permanent” buydown and a “temporary” buydown?
Most of the time when someone is talking about paying points, they are talking about a permanent rate buydown like what we have described so far. The permanent buydown gets you a lower, fixed interest rate that remains the same for the entire term of the loan. With a temporary buydown, however, you start with a lower rate, but it “expires” after a set number of payments and then reverts back to the original rate.
Usually if someone is talking about a temporary rate buydown, they will say something like “2/1 buydown”. That, for instance, means the interest rate will be 2% lower for the first 12 payments and 1% lower for the next 12 payments, and then from payment number 25 through the end of the mortgage, it will revert back to the original interest rate that you would have had if you had not used the 2/1 buydown. Different lenders offer different types of temporary buydowns, but how they work is pretty much the same.
For example, if your original rate is 7%, then with a 2/1 buydown, your first 12 payments would be at a rate of 5% and your next 12 payments would be at 6%. After your first 24 payments, the rest of your payments would be based on your original rate of 7% for the remaining term of your loan.
How is the cost of a temporary buydown calculated?
The cost to do a temporary interest rate buydown is equal to the amount of money you save during the period of reduced monthly payments. It’s that simple.
For instance, if a 2% lower interest rate for the first 12 payments saves you $200 per month ($2,400 total) and the next 12 payments save you $100 per month ($1,200 total), then the total savings would be $3,600 over the course of the first 24 payments. Therefore, $3,600 would be the cost for the 2/1 buydown in this specific example. (Contact your VA Loan Officer for numbers specific to your situation.) That is the amount you would need to get from the seller or someone else, other than you, to cover the cost. The cost is always equal to the savings. There is no “time to recoup” calculation on a temporary rate buydown because you, as the borrower, are not paying for it.
The $3,600 in this example is referred to as “buydown funds” which are deposited in a separate escrow account and essentially used to subsidize the first 24 payments, or whatever time period applies to the particular temporary buydown program that you are using.
Why would anyone use a temporary buydown?
In an interest rate environment where rates have been going up for several years and there is the expectation that rates will come back down in the future, you may want to use a temporary buydown to buy yourself some time. Hopefully, rates come down and you can refinance within the first couple of years, while you have the temporary rate buydown in effect. Also, it’s an opportunity for the seller to help you reduce your monthly payment through a lower interest rate, albeit temporarily, making homeownership more affordable for the initial years of your mortgage.
I'm Rebecca Wooten, and my life revolves around being a wife, mother, cherished friend, and dedicated Realtor. For nearly two decades, the Northwest Hill Country/Lake Travis area has been my home and ....