In the simplest sense, a buydown is a way to buy a lower interest rate for a certain amount of time – and thus reduce monthly payments. The borrower does this either by paying the lender discount on the interest rate or by sending a large payment to the lender to reduce the monthly payments.
While the lump sum payment for the reduction of monthly mortgage payments for the borrower usually only lasts for a few years, the discount point can last Buydown for the duration of the loan. Often, this is done when a borrower does not qualify for a loan at a specific interest rate but has some money in their pocket. This allows the borrower to have some leeway and to take advantage of future potential events, such as salary increases and bonuses.
Although it rather looks like the buyer would pay off the client, it is really the case that the lender keeps the money paid for the rebate. This money is used as a supplement to the borrower’s monthly payment, and when it is gone, the interest rate returns to the rate on the original loan documents.
There are many purchase options. The old-fashioned 2-1 buydown made lower payments for two years, then the original rate was paid from the third year, and the buydown rate goes up. A current variation of this buydown is where the buydown costs remain at their original percentage, but the rate exceeds the rate set in the loan documents. An initial agreement with a 5% interest rate could, therefore, be 6% or more for the remaining loan years.
Variations on the 2-1 buydown are the 3-2-1, where the interest rate goes to 3% below the original rate instead of just 2%. There are also flexible buydown packages available that change the rates at different times during the term of the loan.