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November 16, 2023 // Volume 1, Issue 3
Maximizing Seller Credits with Rate Buy Downs
In response to the affordability issues created by high interest rates, many home sellers—especially builders—are offering generous rate buy-down incentives.
But, as I talk with clients, I've found most are unaware of how to leverage a rate buy-down for the maximum savings.
Here, I'll explain the most popular rate buy-down programs and help you determine how to benefit most from these seller incentives.
How Does a Buy-Down Work?
First, how does the incentive work?
Most commonly, sellers are offering to contribute $10,000 - $25,000 at closing as a seller credit for an interest-rate buy-down.
From what I’m seeing, on a $600k home, a $15k seller credit is typical. Not bad!
Now, how to maximize it.
Let's start with defining a 'rate buy-down.' Today's interest rates hover around 7.5% for a 30-year fixed conventional loan. As the term suggests, a rate buy-down lets you 'buy' a lower interest rate.
There are two types of rate buy-downs you can choose between:
- A permanent rate buy-down
- A temporary rate buy-down
So, what's the difference (apart from the obvious)?
Permanent Rate Buy-Downs
You obtain a permanent rate buy-down by applying the seller credit towards the cost of 'points' (lender lingo for a .25% interest rate reduction). While every lender is different, with $15k, you should be able to buy down the rate by about 4 points, or 1%.
Now, your fixed rate is 6.5% instead of 7.5% for the life of your loan. That may not sound like a lot, but that 1% rate drop will save you about $300/month and close to $100k over 30 years.
Spend $15k to save $100k? That's a fantastic trade-off!
Unless. . .interest rates drop significantly over the next two years.
If, between now and November 2025, rates drop down to 4.5%, you're most likely going to want to refinance to save even more money every month.
So, you refi two years later and drop your rate from the 6.5% you 'purchased' with your buy-down to the new and improved 4.5%. Great! Right?
The Downside to Permanent Buy Downs
But what about that $15k credit? In short, you only took advantage of ~$7,200 of it ($300/month savings in interest x 24 months). Stated negatively: $10,800 goes to waste.
Now, of course, that's a big "if." Who knows? Over the next two years, interest rates could go to 10%+! In that case, won't you be glad you're locked in at 6.5%?
But you should know that's the gamble you take with a permanent rate buy-down.
Temporary Rate Buy Downs
Now, let's discuss temporary rate buy-downs, often called 3-2-1 or 2-1 buy-downs. In this case, the term 'rate buy-down' is somewhat misleading. From the bank's perspective, you're paying the full 7.5% interest rate for 30 years and must qualify for the loan at today's rates.
But the $15k credit from the seller is being applied over 2-3 years to cover the interest you'd otherwise owe on your loan.
Using a 3-2-1 buy down, for example, your effective rates would be:
- Year 1: 4.5%
- Year 2: 5.5%
- Year 3: 6.5%
- Years 4-30: 7.5%
The clear advantage here is a huge reduction in your mortgage payment, especially in the first years of ownership. In Year One, your savings will be ~$720/month or $8,640 for the year. For most people, that's massive!
Of course, Year Two's savings won't be as much.
In fact, if you're not careful in your financial planning, it may feel like your housing costs go up quite a bit in Year Two. And again in Year Three.
The Downsides to Temporary Rate Buy Downs
While you are saving money in Years 1-3 compared to the 7.5% rate, I expect for most people, it won't 'feel' like savings after Year One. To most, it will feel like their housing keeps getting more expensive (to the tune of a few hundred dollars a month year-over-year).
Herein lies the main danger and caution against a temporary rate buy-down.
The other disadvantage is that the $15k credit is entirely consumed by the end of Year 3. In other words, in the end, the seller's $15k credit has saved you exactly $15k in interest—no more.
A Hidden Benefit to Temporary Rate Buy Downs
What if you go the 3-2-1 route and rates drop in Year 2 down to 4.5%?
In this case, there is a hidden benefit to the temporary buy-down.
If you refinance in Year 2, the unused portion of the $15k seller credit is still owed to you! You don't lose any of it, and it can be applied toward your home’s principal balance or closing costs of your refi.
What's Best for You?
So, what should you do?
It depends.
If you're comfortable with a payment at 6.5% and fear rates may stay high or go higher over the next four+ years, your best bet is to use that $15k credit towards a permanent rate buy-down. Again, over 30-yrs, that $15k saves you ~$100k! That's $15k well spent!
But, if you're only planning on being in your new home for 2-3 years or your crystal ball is telling you rates are going to drop significantly in the next three years, and you plan to refi into a lower rate, then the temporary buy-down is what I'd recommend.
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