By Brandon Cornett | © 2015, all rights reserved | Duplication prohibited
to see how much you can afford.
Reader question. “We have been talking to a mortgage broker by email, and one of the things he suggested was something called a 3-2-1 temporary buydown to help us get a lower interest rate. I’m not at all familiar with this term. I want to educate myself a little before I get back to him. Can you explain how a 3-2-1 buydown works, in plain English?”
You’re in luck, because plain English is what we do here at the Home Buying Institute. I know this subject can be confusing, so I’ll do my best to clarify it for you. By the way, you’re doing the right thing by asking what you don’t know. This is one of the most important traits a mortgage shopper can have. So kudos for that!
The 3-2-1 Temporary Buydown Defined
A mortgage buydown allows you to reduce the interest rate on the loan, by paying additional cash up front during the closing process. In other words, it’s a way to reduce the long-term costs of the loan by paying more money at closing. There are two different types — temporary and permanent. The difference between them is pretty straightforward:
- Temporary Buydown — This strategy allows you to reduce the mortgage rate on a temporary basis. The 3-2-1 buydown falls into this category, because it generally works over a three-year period.
- Permanent Buydown — This is when you reduce the rate over the entire term or life of the loan. We won’t be talking about this one much, because your question pertains to the temporary type.
The 3-2-1 mortgage buydown works like this. You pay a certain amount at closing to reduce the interest rate over the first three years of the loan’s repayment term. For the first year, the rate will be 3% lower than the permanent rate. For the second year, it will be 2% below the note rate. And for
the third year, it will be … you guessed it … 1% lower.
Here’s an example:
Let’s say I apply for a mortgage loan, and the lender tells me I qualify for a 6% interest rate (based on my credit score and other factors). I anticipate having some additional expenses during my first few years in the home, because I need to make some renovations to the property. So I want to reduce my mortgage payments during those first few years.
In this scenario, I could use a 3-2-1 temporary mortgage buydown to accomplish my goal of short-term saving. So I would pay a little extra on my closing costs. In exchange for doing this, I would reduce the interest rate (and, by extension, the size of my monthly payments) during years 1 – 3:
- 3% interest during the first year (6% reduced by 3 )
- 4% interest during the second year (6% reduced by 2 )
- 5% interest during the third year (6% reduced by 1 )
- 6% interest for the remainder of the loan’s term
The 3-2-1 designation indicates how much the rate is being reduced, as shown by the bold green numbers above. So in the first year, it is being lowered by three whole percentage points (from 6% to 3%). And so on, for the second and third years. Make sense?
After the third year, the interest rate would return to whatever number the lender assigned during the initial application and approval process. In my example, that was 6% interest. Of course, the key here is to make sure you’re not paying more money to reduce the rate than the amount you’ll save during the first three years.
This article answers the question: How does a 3-2-1 temporary mortgage buydown work? If you have additional questions about home buying and loans, try using the search tool at the top of this website. There are hundreds of articles on this site, so you’re bound to find some useful information. Good luck!