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BUY DOWNS - HOW THEY WORK

Updated:         May 28, 2018

Some Lenders have suspended Buy Down options. This reluctance is driven somewhat by the fact that loan servicing rights are so often transferred that the lenders do not want to be involved with the additional administrative functions associated with the Buy Down. If reinstated, the past guidelines below are expected to prevail.

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. It will "differentiate" the seller's property within the market place and thereby "create an interest" to attract buyers. The buy down can also increase the buyer's "ability to "qualify" for a loan . . . by qualifying at the lower "bought down" interest rate. 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 qualifying 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 6.5%, payments for the first year of the mortgage would be calculated at 4.5%, the second year payments at 5.5% and the third and subsequent years would be at the full 6.5% rate. The buyer qualifies at the second year bought down rate of 5.5% and, thus, qualifies for a larger loan amount and a higher purchase price. (Qualifying at the second year bought down rate is required due to tightened qualifying guidelines. The borrower used to qualify at the first year bought down rate which would have been the 4.5% in this scenario)

A temporary buy down can benefit the buyer whose current income is a bit low but who anticipates that the income will increase during the next two years. The lower payments during the first two year period can help the buyer qualify now and be able to comfortably make the increased payments as income grows. This can be a better alternative in meeting the initial low income problem than the oft used option in the past of acquiring an adjustable rate mortgage . . . often negatively amortized.

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% 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. 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 6.5% to 4.5% for the first year and to 5.5% 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 6.5% loan and the payments at 4.5% and then at 5.5% . . . 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 $2,274. In most cases, this is paid by the seller as an incentive for the buyer to purchase. There are lender paid buy down arrangements as well, but the seller paid option is generally more economical.

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. A buyer may pay the fee for a buy down, but the general consensus is that the buy down is not as attractive. In many cases, the buyer does not have sufficient cash available to contemplate a buy down.

A buy down provision can be used with nearly all forms of financing. While a buy down is not a desirable option in all cases, it can sometimes mean the difference in a buyer being able to qualify and purchase. And, it is an option to some of the other less desirable creative finance programs designed to promote a buyer’s ability to qualify.

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