Real Estate & Mortgage Insights

The Facts about Mortgage Buy Downs

For the average person, making sense of the different types of mortgages available and understanding the industry's terms can be a lesson in patience. It's a constantly changing industry and one that is always trying to make it easier for the home buyer to achieve the dream of home ownership.

With a volatile market and more and more Americans having less than stellar credit, selling a home is not as easy as it once was. But one option that many people may not be aware of is called the "mortgage buy down."

Mortgage buy downs are often not the first choice for home buyers because it does require some money up front. How much? The first three years' worth of interest charges on the mortgage to be exact.

How can paying for the first three years' worth of interest charges help people with poor credit get a home? Because by choosing a mortgage buy down, you will lower your interest rate for the first three years of the loan, thus reducing your monthly payments during that time. This time is used to hopefully increase your income to the point where you will be able to better afford your mortgage when it returns to its regularly scheduled interest rate in the fourth year.

Here's a better example of how a mortgage buy down works:

The most popular mortgage buy down is called the 3-2-1 plan. The original loan taken out on the property is a fully-amortized, 30-year mortgage. After the interest rate "buy down" takes place, the loan's interest rate is dropped by three percent. The first year, the monthly payment is set with the super-low rate. The second year, the interest rate increases by one percent (an increase of about $200 to the average mortgage payment). The third year sees another one percent increase. From the fourth to the 30th month, the loan features the original fixed-interest rate.

Here's how it looks in the world of actual numbers:

Let's say you purchase a home and the amount mortgaged is $285,000. With a 30-yr mortgage, set at 6.21 percent, the monthly payment would be $1,747.39 or $20,968.68 per year.

For the first year of a mortgage buy down, your mortgage will be set at 3.21 percent and your monthly payment would be $1,234.09. This results in a first year savings of $6,195.60, all of which is interest.

The second year, your mortgage will be set at 4.21 percent and your monthly payment would be $1,419.46. You will see a savings of $3,935.16 in interest that year.

The third year of your mortgage, your interest rate will increase another percentage to 5.21 percent. Your monthly payment will increase to $1,613.79, a savings of $1,603.20 for the year. From the fourth year on, you will pay the regular monthly payment of $1,747.39.

Now comes the hard part. In order to take advantage of the significantly lowered interest rate, you will have to pay the money you will ultimately save up front at closing. It's almost like pre-paying your interest. As a matter of fact, that's exactly what you're doing. At closing, you will pay the $11,878.15 that you will save over the next three years.

How does this help? Well, if you can reduce the money you're putting down on the home and work the mortgage to free up more money to buy it down, you can use the advantage to get into a bigger home in a better location than what you may otherwise not have been able to afford. Then, over the next three years, your income will hopefully increase to the point where you can more easily afford the original monthly payment.

A mortgage buy down is not without its risks, of course. If you or someone in your household loses a job that is vital to the family income, or your income unfortunately declines over the three years, you will have a difficult time managing the yearly increase to the mortgage. This is why mortgage buy downs are not as popular as more traditional lending practices, but they do have their place in a constantly changing market.

If you have less than stellar credit, and you are changing jobs, or you have a spouse set to return to work, a mortgage buy down can really help you get ahead and get you into a much better home than you would otherwise be eligible for.