Mortgage buydowns -- what is that? You've probably heard the term before, but if you're like most people, it might not make a lot of sense to you. In part, the reason it may sound confusing is because a mortgage buydown rarely results in a permanent lower monthly payment nowadays; it's only temporary.

Mortgage Buydowns Do Not Involve Negative Amortization
For many borrowers, a mortgage buydown is more advantageous than choosing, say, an adjustable loan with a payment option that allows for negative amortization like an Option ARM. That's because with mortgage buydown programs, your mortgage payment always includes principal and interest. This means every time you make a payment, your mortgage balance grows smaller instead of bigger.

Basics of Today's Popular Mortgage Buydowns
Popular mortgage buydowns work like this.

oPayments are reduced and figured on a lower interest rate over a specific term.
oThe difference between the "real" note rate and the lowered interest rate is paid in cash by the seller or the buyer.
oThink of it like a subsidy. It's like socking away $1200 in the bank and withdrawing $100 every month for 12 months to help make your mortgage payment.

The 3-2-1 Mortgage Buydown

oThis is a 30-year fully amortized mortgage.
oThe interest rate increases 1% every year for the first three years.
oThen the interest rate is fixed for the remaining term.
Here is an example. Say your loan balance is $350,000 and the interest rate is fixed at 6.75% for 30 years. The seller (or you) could "buy down" the interest rate by paying a lump sum of $15,853. This is how it works:

1.First-year interest rate is 3.75%, payable $1,621 per month.
2.Second-year interest rate is 4.75%, payable $1,826 per month.
3.Third-year interest rate is 5.75%, payable $2,043 per month.
4.Years four through 30, interest rate is 6.75%, payable $2,270 per month.

oFirst-year savings (as compared to $2,270 per month) is $649 per month or $7,790.
oSecond-year savings (as compared to $2,270 per month) is $444 per month or $6,332.
oThird-year savings (as compared to $2,270 per month) is $228 per month or $2,731.
Add up the annual savings: $7,790 + $6,332 + $2,731 = $15,853. Therefore, it costs $15,853 to buy down the interest rate and payments for three full years.

Benefits of 3-2-1 Mortgage Buydown

oThe borrower qualifies for this loan at the 3.75% interest rate and payment amount of $1,670 versus the real rate of 6.75% and the payment of $2,270.
oInstead of the payment jumping all at once, it goes up in smaller increments, about $200 each year, for the first three years.
oIt keeps payments low for 36 months for borrowers whose income is expected to later increase. Perhaps a spouse is returning to work after a hiatus or a person expects to graduate and land a higher paying job with that newly earned degree.

The 2-1 Buydown Mortgage

oThis is a 30-year fully amortized mortgage.
oThe interest rate increases 1% every year for the first two years.
oThen the interest rate is fixed for the remaining term.
Here is an example. Say your loan balance is $350,000 and the interest rate is fixed at 6.75% for 30 years. The seller (or you) could "buy down" the interest rate by paying a lump sum of $8,063. This is how it works:

1.First-year interest rate is 4.75%, payable $1,826 per month.
2.Second-year interest rate is 5.75%, payable $2,043 per month.
3.Years three through 30, interest rate is 6.75%, payable $2,270 per month.

oFirst-year savings (as compared to $2,270 per month) is $444 per month or $6,332.
oSecond-year savings (as compared to $2,270 per month) is $228 per month or $2,731.
Add up the annual savings: $6,332 + $2,731 = $8,063. Therefore, it costs $8,063 to buy down the interest rate and payments for two full years.