In early December, 75% of nationally surveyed home builders confirmed they are buying down buyers’ mortgage rates to make payments more affordable. Our survey indicates 32% of builders are buying down the full 30-year term and another 30% of builders are temporarily reducing the rate for the first two years of the mortgage. The remaining 13% of builders identified other less common buydowns. Builders pay these costs up front, effectively reducing monthly payments by prepaying for some of the buyers’ interest on the loan. Few resale sellers are offering these savings to prospective buyers.
Two popular strategies involve builders lowering the mortgage rate for the buyer:
- 30-year rate buydown: Builders are contributing 5%–6% of the home purchase price up front to lower the 30-year mortgage rate by 1%–2% typically. For example, builders may reduce the rate from 6.5% to 5.0% using last week’s Freddie Mac mortgage rate.
- 2-1 temporary rate buydown: Builders are contributing 2% of the home purchase price up front, which lowers the first-year mortgage rate by 2%, and the second-year mortgage rate by 1%. Using last week’s 6.5% rate, a buyer’s rate would be 4.5% in year one, 5.5% in year two, and 6.5% thereafter. Borrowers still have to qualify at the 6.5% rate to benefit from a reduced payment in the first few years, giving them some breathing room to perhaps spend money on furniture or other needed items.
Because buyers have to qualify at the highest rate that will occur during the 30-year term, builders using the 2-1 temporary buydown tell us some buyers still cannot qualify. By shifting to a 30-year rate buydown, builders can lower the rate and monthly payment used to qualify struggling buyers.
Incentives have become a necessity in today’s new home sales environment and are helping preserve builders’ backlogs as confirmed by builders in our surveys:
- “Everyone is requiring incentives, including price reductions, rate buydowns, closing costs, etc.” (Riverside-San Bernardino, CA)
- “Rate buydowns and/or rate lock promotions are working best. Sales are still slow; however, cancellation rates have decreased.” (Colorado Springs, CO)
- “100% of backlog is being offered some kind of rate buydown that is comparable to new sales.” (San Antonio, TX)
Regions with the weakest new home sales rates have the highest percentages of builders who are utilizing rate buydowns, as demonstrated in the graph below.
Explaining rate buydowns
Because they guarantee roughly 50% of US mortgages, guidelines established by Fannie Mae and Freddie Mac significantly impact the types of buydowns that home builders offer. Most mortgage originators want to issue conforming loans that can be sold into the secondary market. Non-conforming loans are usually held on the originator’s balance sheet and require additional cash reserves to meet regulations that protect the banking system and consumers.
Fannie and Freddie limit temporary rate buydowns to three years and the rate cannot step up more than 1% each year. Therefore, the largest temporary buydown a home builder can offer with a conforming loan is a 3-2-1 program.
- For a 3-2-1 buydown the rate is reduced to 3% below market in the first year of the loan, 2% below in the second year, and 1% below in the third year. Years 4-30 revert to the market rate and the buyer has to qualify at the contracted market rate.
- With a 2-1 rate buydown the rate is set 2% below the market rate in the first year and 1% below market in the second year, reverting to the market rate for years 3-30.
- FHA and VA loans follow the same limitations—no more than three years and only 1% rate steps annually.
To buydown the rate for the term of the loan, builders pay upfront for points. Each 0.25% reduction in the rate typically costs 1% of the loan amount.
- Some builders purchased forward commitments which provide tranches of money at below market rates to originate mortgages for their buyers, as an alternative to buying down the rate for the term of the mortgage.
Guidelines for rate buydowns
- Rate buydowns must be for a home purchase, not a refi or construction loan, and are not usually offered for adjustable-rate mortgages.
- For loans guaranteed by Fannie and Freddie, seller contributions are limited to 3% of the mortgage principal if the buyer’s down payment is less than 10% and capped at 6% when down payments exceed 10%. FHA mortgages limit seller contributions to 6% regardless of the down payment amount.
- Lenders making jumbo loans, which are not guaranteed by Fannie and Freddie, may restrict buydowns by applying their own guidelines.
- Often a builder’s related mortgage company or joint venture partner contributes to the cost of the rate buydown.
Builders’ costs to buydown rates
The dollar amount the builder pays for the buydown varies wildly by loan amount, the buyer’s down payment, type of loan, and the term of the buydown, ranging from a low of roughly $6K to as high as $48K. These tables show several examples.
Prospective buyers considering a new home purchase should plan to visit the new home sales offices, where agents will demonstrate the power of rate buydowns and forward commitments to make those monthly payments more affordable.