As mortgage rates began to increase in the second half of 2022, temporary mortgage rate buydowns increased in popularity, possibly explaining some of the surprising strength of home buying demand as rates remain elevated.
A temporary rate buydown is a mortgage that allows homebuyers to reduce their interest rate for a limited period. The size of the reduction and length depends on the type of mortgage. For example, nearly two out of three recent temporary rate buydowns are a “2-1”, where homebuyers pay 2 percentage points less in the interest rate the first year, 1 percentage point less the second year, and the full rate after that. Other types include a “3-2-1,” a “1-0” and a “1-1.” No matter the type of buydown, lenders must qualify the homebuyers at the full interest rate.
In the second half of 2022, the share of temporary buydowns spiked when average mortgage rates climbed over 6% for the first time since 2008. Though the surge in temporary buydowns has since abated somewhat, the increase in buydowns may signal a willingness by homebuyers to pay more over the life of their loan to lower their monthly payments in the short term, at least for the first several years of their mortgage.
There may be a trade-off, however. Homeowners with temporary buydown options received interest rates that were 15 basis points higher on average. This implies that by choosing the buydown option, borrowers may end up paying slightly more money throughout the life of the mortgage, depending on when they refinance or move. This trade-off isn’t surprising since the lower initial payments need to be made up by either higher upfront charges, a higher rate, or both.
The cost to cover the difference in rates is normally paid upfront by the borrower, builder, seller, or other interested parties. These products have been especially popular in the financing of new homes since home builders—who generally partner with mortgage company affiliates—can simultaneously negotiate the sale price and the mortgage.
A variation in mortgage rates across lenders has been higher than usual over the past year. While buydowns are one potential factor impacting this spread in available rates, we don’t think they are the dominant story. That is because when we check for discount points in closing data, we still see an increase in the dispersion of rates. Similarly, we noticed a widening in the distribution of posted rates on lenders’ websites.
The fact remains: Temporary rate buydowns have fallen in recent months. However, our research shows that in higher-rate environments, temporary buydowns provide some marginal demand and relief to buyers and sellers.
