Every so often I run across a reference to a "rate buydown" I don't like to use them because they don't benefit the client, but I should explain them, what they are, and how they work.

A rate buydown is where for an upfront price, the lender agrees to give you a lowered interest rate for a time. 2/1/0 buydowns, where the rate is two percent lower the first year, one percent lower the second year, and then at the loan rate the third year, are the most common, but I've seen one year buydowns of two percent, two year buydowns of one percent for those first two years period, and any number of other tricks.

Now, this isn't free. A 2/1/0 buydown usually costs three points. In fact, what usually happens is the three points go into an escrow account somewhere where they pay out the money to make up the difference in interest to the lenders as the loan goes along. When the buydown period is over, the lender who originally funded your loan then gets to keep what's left over.

Now, here's what this means to you. Let's make this easy. Say you would have had a \$291,000 loan, fixed at 7 percent, without a buydown. But with the buydown, you have a \$300,000 loan at 5 percent the first year, six percent the second, and 7 percent from there on out. In order to really understand this, let's first take a look at your loan without a buydown:

 Month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Balance \$291,000.00 \$290,761.47 \$290,521.55 \$290,280.23 \$290,037.50 \$289,793.35 \$289,547.78 \$289,300.78 \$289,052.34 \$288,802.45 \$288,551.10 \$288,298.28 \$288,043.99 \$287,788.22 \$287,530.95 \$287,272.19 \$287,011.91 \$286,750.12 \$286,486.80 \$286,221.94 \$285,955.54 \$285,687.58 \$285,418.06 \$285,146.97 Payment \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 \$1,936.03 Interest \$1,697.50 \$1,696.11 \$1,694.71 \$1,693.30 \$1,691.89 \$1,690.46 \$1,689.03 \$1,687.59 \$1,686.14 \$1,684.68 \$1,683.21 \$1,681.74 \$1,680.26 \$1,678.76 \$1,677.26 \$1,675.75 \$1,674.24 \$1,672.71 \$1,671.17 \$1,669.63 \$1,668.07 \$1,666.51 \$1,664.94 \$1,663.36 Principal -\$238.53 -\$239.92 -\$241.32 -\$242.73 -\$244.14 -\$245.57 -\$247.00 -\$248.44 -\$249.89 -\$251.35 -\$252.82 -\$254.29 -\$255.77 -\$257.27 -\$258.77 -\$260.28 -\$261.79 -\$263.32 -\$264.86 -\$266.40 -\$267.96 -\$269.52 -\$271.09 -\$272.67 Tot Int. \$1,697.50 \$3,393.61 \$5,088.32 \$6,781.62 \$8,473.50 \$10,163.97 \$11,852.99 \$13,540.58 \$15,226.72 \$16,911.40 \$18,594.62 \$20,276.36 \$21,956.61 \$23,635.38 \$25,312.64 \$26,988.40 \$28,662.63 \$30,335.34 \$32,006.51 \$33,676.14 \$35,344.22 \$37,010.73 \$38,675.67 \$40,339.02 Tot Prin \$238.53 \$478.45 \$719.77 \$962.50 \$1,206.65 \$1,452.22 \$1,699.22 \$1,947.66 \$2,197.55 \$2,448.90 \$2,701.72 \$2,956.01 \$3,211.78 \$3,469.05 \$3,727.81 \$3,988.09 \$4,249.88 \$4,513.20 \$4,778.06 \$5,044.46 \$5,312.42 \$5,581.94 \$5,853.03 \$6,125.70

Now let's look at it with the buydown:

 Month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Balance \$300,000.00 \$299,639.54 \$299,277.57 \$298,914.09 \$298,549.10 \$298,182.59 \$297,814.56 \$297,444.99 \$297,073.87 \$296,701.22 \$296,327.01 \$295,951.24 \$295,573.90 \$295,257.63 \$294,939.77 \$294,620.32 \$294,299.27 \$293,976.62 \$293,652.36 \$293,326.47 \$292,998.96 \$292,669.81 \$292,339.01 \$292,006.55 Payment \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,610.46 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 \$1,794.15 Interest \$1,250.00 \$1,248.50 \$1,246.99 \$1,245.48 \$1,243.95 \$1,242.43 \$1,240.89 \$1,239.35 \$1,237.81 \$1,236.26 \$1,234.70 \$1,233.13 \$1,477.87 \$1,476.29 \$1,474.70 \$1,473.10 \$1,471.50 \$1,469.88 \$1,468.26 \$1,466.63 \$1,464.99 \$1,463.35 \$1,461.70 \$1,460.03 Principal \$360.46 \$361.97 \$363.48 \$364.99 \$366.51 \$368.04 \$369.57 \$371.11 \$372.66 \$374.21 \$375.77 \$377.33 \$316.28 \$317.86 \$319.45 \$321.05 \$322.65 \$324.26 \$325.89 \$327.51 \$329.15 \$330.80 \$332.45 \$334.11 Tot Int. \$1,250.00 \$2,498.50 \$3,745.49 \$4,990.96 \$6,234.92 \$7,477.35 \$8,718.24 \$9,957.59 \$11,195.40 \$12,431.66 \$13,666.35 \$14,899.48 \$16,377.35 \$17,853.64 \$19,328.34 \$20,801.44 \$22,272.94 \$23,742.82 \$25,211.08 \$26,677.71 \$28,142.71 \$29,606.06 \$31,067.75 \$32,527.79 Tot Prin \$360.46 \$722.43 \$1,085.91 \$1,450.90 \$1,817.41 \$2,185.44 \$2,555.01 \$2,926.13 \$3,298.78 \$3,672.99 \$4,048.76 \$4,426.10 \$4,742.37 \$5,060.23 \$5,379.68 \$5,700.73 \$6,023.38 \$6,347.64 \$6,673.53 \$7,001.04 \$7,330.19 \$7,660.99 \$7,993.45 \$8,327.56

It is also to be noted that in the very next month, your payments go to \$1982.23, as opposed to the \$1936.03 they would have been in the first place, and that they will stay there the rest of the loan, all 336 months should you keep it the rest of that time. Why? Because your balance is larger than it otherwise would have been, so the payment is higher, in this case by \$46.20, due to the higher loan amount.

Finally, let's look at the differences:

 Month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Escrow Acct. \$8,552.50 \$8,176.27 \$7,796.79 \$7,414.04 \$7,028.00 \$6,638.63 \$6,245.92 \$5,849.83 \$5,450.34 \$5,047.43 \$4,641.06 \$4,231.22 \$3,817.87 \$3,647.29 \$3,475.21 \$3,301.60 \$3,126.46 \$2,949.78 \$2,771.53 \$2,591.72 \$2,410.32 \$2,227.32 \$2,042.72 \$1,856.50 Net cost \$8,552.50 \$7,982.95 \$7,413.19 \$6,843.21 \$6,273.02 \$5,702.62 \$5,132.02 \$4,561.21 \$3,990.21 \$3,419.02 \$2,847.64 \$2,276.08 \$1,950.65 \$1,687.67 \$1,424.51 \$1,161.18 \$897.67 \$633.98 \$370.13 \$106.11 -\$158.09 -\$422.44 -\$686.97 -\$951.65

What this means is that your lender's escrow account ends up with \$1850 that they get to keep, on top of everything else they made from the loan. The final column is the net cost to you, what you paid to get it less the interest it saved you. Hey, look at this! In month 21 it goes negative! You must be saving money if you keep it that long, right?

Nope. This is a temporary and illusory savings phenomenon, and I don't know of any way to make it permanent. You see, the benefits stop in month 24. They are over. Kaput. Gone. That's all, folks. But you owe \$6798.14 more (at the start of month 25, not illustrated above) than you would have without the buydown. There are exactly three possibilities as to what happens. First, that you keep the loan. Due to the extra interest you're paying every month, you are negative again in month 56, and it keeps getting worse the longer you keep the loan. After 120 months of the loan, you are \$1755 down. This actually peaks in month 242 at \$3351 negative, then starts decreasing, but you don't get it back before the loan is paid off.

The second possibility is if you refinance the loan. Let's say you get a really fantastic deal and refinance at 5 percent on a 30 year fixed rate loan, and I'll even give you that your higher balance doesn't cost you any more in fees. Your payment is \$85.35 per month higher than it would otherwise have been, your interest charges \$28.32 higher (and the difference represents you paying the principal off faster if you don't pay for a buydown). Your savings is gone in less than three years, and there's nothing you can do about it.

The third and final possibility is that you sell the house. You get \$6798.14 less in your pocket. This means that you don't have \$6798.14 earning money for you in the stock market. At ten percent your benefit is gone in less than a year and a half. If you take the money and buy another property, that's \$6798.14 higher your loan balance will have to be. Let's say you get that same fantastic 5% loan we talked about two paragraphs ago on the new property. Guess what? The same math applies here also. There is no way to win in the end with a buydown, unless someone else pays for it (for example, seller paid closing costs).

So they are a piece of garbage. Why are buydowns attractive, and why do otherwise rational people sign up for them?

Because they lower the payment for a while. People choose loans based upon the payment. In particular, they choose loans based upon the payment in the first check they are going to have to write. Most people figure that the check they are going to have to write two or five years out isn't important. Unscrupulous lenders and loan officers know this. That's why the (censored) negative amortization loans are so popular, despite them being time-delayed financial poison. So don't shop for loans based upon the payment, and if someone starts talking about ways to cut the payment as opposed to the interest rate, put your hand on your wallet and leave. If they persist, drag them out into the sunlight and put a wooden stake through their heart. It's the only way to be sure.

Before I go, I want to mention one specific group that gets targeted for these things, and that is veterans. The Veterans Administration loan, aka VA loan, has the ability to roll (not coincidentally) three points closing cost over and above the cost of the home into the loan. Most military folks are busy learning their trade, which is usually not something having to do with finance. Indeed, I've never heard of any MOS that included this type of financial training. So when the loan officer whispers sweet nothings into their ear about cutting the payments for the first couple of years, they don't know any better and they sign right up. They could have used those three points for something potentially useful, like discount points that buy you a lower rate for the entire term of a VA loan. If you keep it long enough, they will eventually net you money and the VA only accepts fixed rate loans, not ARMS or hybrids. The veterans could just not pay those three points, and not start out with what is basically negative equity. But rate buydowns make a loan appear attractive on the surface to someone with insufficient financial training, while costing them money in the long term and allowing the initial lender to make more money than they otherwise would.

Caveat Emptor.

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This page contains a single entry by Dan Melson published on July 6, 2007 10:00 AM.

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