Here's how a permanent buydown could look in this situation:
Goals & Planning |
Dec 14, 2023
Buying Down Mortgage Rates
Home Buying Strategies for High Interest Rate Environments
In the midst of pandemic related economic stimulus, lockdowns, work from home mandates and social distancing, the housing market experienced an unprecedented boom, with many homes going under contract over the asking price just hours after hitting the market. Much of the real estate bonanza was made possible because the Fed dropped interest rates in March 2020 to an historic low of 0.25%, thereby reducing homebuyer’s borrowing costs. Home prices skyrocketed – in 2020 the median price for a single-family home in King County was $724,900. In 2021 that same single-family dwelling had a median price of $828,100 – a 14.24% increase1.
Fast forward to today and the housing market looks drastically different. To combat inflation, the Fed embarked on the most aggressive rate hike regime in history starting in early 2022. The Fed Funds rate went from essentially 0% to 5.5% in the span of 16 months. As a result, mortgage rates have more than doubled from their lows around 3% to around 7.5% today. Despite the rate increase, home prices haven’t dropped. Why? The supply of houses on the market is historically low, with a direct line being drawn to the low interest rates of the pandemic. Many existing homeowners took advantage of the extremely low rates in 2020 and 2021 to refinance, locking in a lower fixed rate and monthly mortgage payment. While the adage typically goes “Marry the house and date the mortgage,” many homeowners have flipped the script and prefer to maintain the sub 3% mortgage rates they were able to secure during the pandemic.
With fewer homes on the market, sellers have been able to set higher prices for the properties they are selling. Conversely, with higher mortgage rates, a homebuyer’s purchasing power may be reduced, causing homes to stay on the market longer, prompting sellers to consider reducing the price. Add it all up and we find ourselves in the most unaffordable housing market in the history of the U.S.
It’s not all bleak though. For buyers, sellers, and real estate agents in the know there is a creative but little used strategy that can help sellers avoid a price reduction and aid buyers in stretching their dollar a little further.
Buying Down Mortgage Rates: A little-known strategy, used to great effect
There are two options for buying down a mortgage rate: a permanent rate buydown OR a temporary rate buydown.
A permanent rate buydown, also known as buying points, is essentially a form of pre-paid interest that is paid up front in exchange for a lower interest rate and monthly payments. Buying points reduces the buyer’s mortgage rate by about 0.25 percentage points and typically costs 1% of the loan amount. Pricing is abnormal right now, according to some mortgage industry sources, so you’ll definitely want to shop mortgage companies to see who has the best deal on rate buy-downs. Running with the buy-down formula we mentioned above, let’s suppose a house is listed for $800,000 (the current median home price in Seattle according to Realtor.com). Let’s look at a scenario with a buyer who has a 20% down payment, resulting in a mortgage amount of $640,000. A .25% buy-down per point, at 1% of the loan amount, would cost $6,400 up front.
A few things to consider when buying points:
- What’s the break-even on the mortgage? The break-even point is when a buyer has paid off the cost of buying the points. In the above table, the break-even point to purchase 1 point is 5 years.
- How long do you plan on staying in the home? If the answer is “not very long” or “less than the break-even point”, it may not be beneficial to buy down the mortgage.
- Where do you think interest rates will be in the next couple of years and if lower, do you plan on refinancing? If you are betting on interest rates lowering in the near-term and plan on refinancing your mortgage before the break-even point, a permanent buydown strategy may not be right for you.
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How to calculate the break-even point:
Continuing with the previous example, with a loan of $640,000 and a 7% interest rate, purchasing 1 point brings the mortgage rate to 6.75%. The monthly payment reduces from $4,258 to $4,151 – a monthly savings of $107. The cost to buy-down the point: $6,400. Divide the cost by the monthly savings amount: $6,400/$107 = 59.81. So, the break-even point is approximately 60 months or 5 years.
Buying discount points on a mortgage can be an effective way to save money over the long-term, providing the buyer plans to stay in the home past the break-even point. Discount points can be purchased by the buyer, seller, or other interested third party. Parents can even use this strategy to help a child purchase a home; rather than contributing to the down payment (which may not move the needle on monthly payments). Parents can instead buy points to help reduce the overall interest rate on the mortgage, reduce monthly payments, and ultimately increase their child’s monthly cash flow.
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The second option for buying down a mortgage is a temporary rate buy-down. Traditionally, temporary rate buy-downs are paid for by the seller and act as pre-paid interest for the buyer. Essentially, the seller pays the difference between what the buyer’s mortgage rate is and a discounted rate for a contracted period, typically no more than three years. This can be a beneficial strategy on the seller’s part, rather than dropping the list price of your home. The situation can be a win-win for all parties: the seller maintains the desired price of their home while the buyer can initially save money in the short term, and potentially look at refinancing once the temporary buy-down period has concluded.
How a temporary rate buydown works:
Depending on the terms of the buy-down, the buyer’s monthly mortgage payments will be reduced in some capacity in the first, second, and/or third year of homeownership due to a lower interest rate, then in the fourth year reset to monthly payments at the regular mortgage rate. Temporary buy-downs can occur in varying terms: 1-0, 2-1, or 3-2-1. Referring to the previous scenario, the below chart outlines the total savings to the buyer/cost to the seller of each situation.
1-0: The mortgage rate and monthly payments are lower for the first year of the loan and increase for the second year onward.
- Year 1: 6% mortgage rate with a $3,837 monthly payment
- Years 2-30: 7% mortgage rate with a $4,258 monthly payment
Total Savings for buyer/cost to seller: $5,052
2-1: The mortgage rate and monthly payments are lower for the first year, increase in the second year, and reach the contracted mortgage rate in the third year onward.
- Year 1: 6% mortgage rate with a $3,837 monthly payment
- Year 2: 6.5% mortgage rate with a $4,045 monthly payment
- Years 3-30: 7% mortgage rate with a $4,258 monthly payment
Total savings for buyer/cost to seller: $7,608
3-2-1: The mortgage rate and monthly payments are at the lowest rate in the first year, rise in the second and third years respectively, and return to the contracted mortgage rate in the fourth year.
- Year 1: 6% mortgage rate with a $3837 monthly payment
- Year 2: 6.5% mortgage rate with a $4,045 monthly payment
- Year 3: 6.75% mortgage rate with a $4,151 monthly payment
- Years 4-30: 7% mortgage rate with a $4,258 monthly payment
Total savings for buyer/cost to seller: $8,892
A temporary rate buy-down could be a good option for homebuyers who believe interest rates will drop by the end of the temporary period, allowing you to refinance your mortgage with less focus on the break-even point of a permanent rate buy-down. This strategy might also be a good option if a buyer thinks they may not stay in the home for more than 3-5 years. From the seller’s perspective, temporary rate buy-downs can offer a more beneficial way to sell a home without reducing the listing price (as outlined in the table below).
Ultimately, when deciding what type of rate buy-down to employ when purchasing or selling a home, take a look at the big picture. Do you plan on staying in this home long-term? Do you think interest rates will come down in the near term, allowing you an opportunity to refinance?
If you are interested in learning more about rate buy-downs and how this strategy could work for your situation, Contact Us or call (425) 778-6160 to schedule a meeting with your CWM advisor. We’re always happy to help at Comprehensive Wealth Management.
For more information on markets or other financial topics, we invite you to visit the News section of our website.
*This material is not intended to replace the advice of a licensed real estate agent or mortgage broker. Consultation with the appropriate professional should be done before any financial commitments regarding the issues related to the situation are made.
1 Groover, Heidi. “A $7 Million Condo and More Takeaways from Seattle’s Red-Hot 2021 Housing Market.” The Seattle Times, The Seattle Times Company, 21 Jan 2022, https://www.seattletimes.com/business/real-estate/five-takeaways-from-seattles-red-hot-2021-housing-market/#:~:text=San%20Juan%20County%20recorded%20the,for%20%24650%2C000%2C%20up%2022.6%25.
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