The 2-1 Buydown: What is it and how can it help you?

A 2-1 buydown is an arrangement between the buyer and seller, builder, or lender to lower the interest rate by 2% for the first year of the mortgage, and by 1% for the second year of the mortgage. This is a great strategy to lower costs and save money.

Predictions about the housing market are about as accurate as weather forecasts. The housing market is volatile for a variety of reasons, from rising mortgage rates to bidding wars and cool buying seasons.

If you are looking to purchase a home, particularly if this is your first time, you are likely researching the different types of loans available to you. Unless, that is, you happen to have enough cash on hand to buy a home in your market (and congrats to you!).

For homebuyers who need a mortgage, this article looks at the 2-1 buydown financing arrangement, a popular option for buyers in the first year of homeownership.

How 2-1 Buydowns Work

With a 2-1 temporary buydown agreement, you will pay 2% below the market mortgage rate for your first 12 months, then 1% below for the next 12 months. In year 3, you will pay the regular rate for the remainder of the mortgage (usually 360 months total).

What Makes 2-1 Buydowns Possible?

Depending on the situation, either the builder, lender, or seller pays for the buydown. In some cases, the cost for the buydown may be split between different parties involved in the transaction.

The funds are collected during closing and placed in an escrow account. Escrow is a common legal arrangement in which a third party holds money until a particular condition is met.

A 2-1 Buydown Example

Examples always make it easier to understand numbers and percentages, right? So imagine this:

You’re an aspiring homeowner shopping for the best loan for your needs. You find your dream home — awesome!

After your down payment, you will need a mortgage to cover the remaining $650,000. One lender offers you a 6.00% interest rate for a 30-year term. You can expect 360 monthly payments of $3,897.08 each.

The First Year

Suppose that you secure a 2-1 buydown for this loan. In that case, your interest rate in the first year will be 4.00%. Instead of a monthly payment of $3,897.08 throughout the life of the loan, you will pay $3,103.20 each month for the first year.

This saves you $793.88 per month, for a total savings of $9,526.56.

The Second Year

In your second year, your interest rate will be 5.00%. Your monthly payment will be $3,489.34 for the next 12 months, saving you $407.74 per month.

The total savings in your second year will be $4,892.88.

In your third year, you will pay the regular rate of 6.00%, and your monthly payments will be $3,897.08 until your mortgage is paid off.

Why Is a Low Interest Rate Important for a Buyer?

Even though the lower rates stay for only the first 24 months, you’ll save $14,419.44 in mortgage payments with a 2-1 buydown in the example. That $14,419.44 is the amount that is put into escrow during closing. It will be covered by either you (the buyer), the seller, the lender, the builder, or a combination of parties

Negotiating the Buydown

During the home buying process, you can negotiate with the seller or builder to fund the upfront fee associated with getting a 2-1 buydown by including the buydown in the seller concessions.

These negotiations are why a clever real estate agent is a useful asset. A good agent will have the knowledge and experience needed to fight for you during the offer stage.

Why Sellers Offer 2-1 Buydowns

It may seem like in a 2-1 buydown situation, the buyer wins while the seller loses, but this isn’t always true.

Sellers who have a property that has been stagnating on the market for a while can benefit from offering a 2-1 buydown. These kinds of offers incentivize buyers to purchase.

The year 2021 was a crazy time for home sellers. In 2021, many sellers got multiple offers within hours of listing their homes. Then, the frenzy died down, and 2022 has been remarkably different, with many homes sitting on the market for weeks or months.

Offering a 2-1 buydown to buyers doesn’t come without its own price, of course. Although sellers benefit from finally selling their property, the 2-1 buydown can ultimately reduce the amount they net from the sale.

Benefits of a 2-1 Buydown

For homebuyers, a 2-1 buydown is full of potential benefits.

Pay Less

With a 2-1 buydown, your interest rate is lower for the first 24 months of homeownership. Therefore, your monthly payments are also lower.

Helps Prepare You for Your Mortgage by Rebuilding Savings

Closing costs, moving expenses, new furniture, and small renovation projects can quickly zap the savings of new homeowners. A 2-1 buydown gives you a chance to rebuild your savings.

Lower mortgage payments for the first two years can be a great way to ease into homeownership and prepare you for full mortgage payments. Additionally, if you expect your income to rise from year to year, you will be in a better position to make the full mortgage payments.

Save Money

Although you are paying less, you should still budget for the full mortgage amount. The remaining money should go into a savings account, which you can then use to address unexpected repairs or reach other financial goals.

Afford More

Securing a 2-1 buydown deal with a seller can help you afford both a larger mortgage and a more expensive home than you might otherwise qualify for.

Downsides of a 2-1 Buydown for the Buyer

As with anything in life, every good thing has its price, and a 2-1 buydown isn’t exempt. There are certainly risks associated with this arrangement for the buyer.

High Upfront Costs

Unfortunately, if the seller, lender, or builder doesn’t want to pay, a 2-1 buydown likely isn’t worthwhile for you.

Limits of a 2-1 Buydown

Unfortunately, 2-1 buydowns have some limitations.

Some state and federal mortgage programs do not offer 2-1 buydowns. Many lenders do not offer them, either. If they do, terms for 2-1 buydowns will vary from lender to lender.

They may be available on fixed-rate FHA loans, which are loans that help many first-time buyers attain homeownership. With FHA loans, 2-1 buydowns are only available for new mortgages, not refinancing. Although you will pay a discounted rate for the first two years, you have to qualify for the full note rate in order to warrant a 2-1 buydown loan agreement.

2-1 Buydown Alternatives

There are several alternatives to the 2-1 buydown that might be more appropriate for you, depending on your situation.

1-0 Buydown

A 1-0 buydown is where you pay an interest rate that is 1% lower than the market mortgage rate for the first 12 months.

You won’t have as many lower mortgage payments as you would with a 2-1 buydown, but you’ll also need less money upfront.

1-1-1 Buydown

A 1-1-1 buydown is — you guessed it — where you pay an interest rate that is 1% lower than the market mortgage rate for the first three years.

3-2-1 Buydown

Another clever and creative name for a real estate contract, the 3-2-1 buydown is just what it sounds like.

In the first year, your interest rate is 3% lower. The second year, it’s 2% lower, and lastly for the third year, it’s 1% lower. After that, it adjusts back up to the original mortgage rate.

This buydown has the potential for more savings, but the escrow payment is going to be significant.

2-1 Buydowns vs. Adjustable-Rate Mortgages

Another alternative to a 2-1 buydown is an adjustable-rate mortgage.

This is a type of mortgage agreement with an interest rate that adjusts based on the market. These mortgages usually start with a lower interest rate compared to fixed-rate mortgages, making them particularly appealing for buyers who want the lowest possible mortgage rate starting out.

How Adjustable-Rate Mortgages Work

Adjustable-rate mortgages have two periods: the initial fixed period and the adjustable period.

During the fixed period, your interest rate doesn’t change. This period, depending on your loan agreement, lasts anywhere from five to ten years.

The adjustment period is what follows for the remainder of your mortgage agreement. During the adjustment period, your interest rate either goes up or down based on an established benchmark.

The lender decides on the benchmark. For example, a lender may decide that the U.S. Treasury rates are the benchmark. This rate will serve as the basis for any reset calculations.

2-1 Buydown or ARM Loan — Which Is Better?

It depends on you and your situation, but in general, 2-1 buydowns offer more predictability.

Because 2-1 buydowns are fixed-rate loans, you can clearly anticipate your payment in year 1, year 2, and years 3 through 30.

Both loans offer more affordable homeownership in the first few years, but the best way to determine which is better for you is to speak with a trusted loan professional.

Making the Decision on a Buydown

There is a time and place for the 2-1 buydown.

The 2-1 buydown is not for homebuyers who cannot afford the full market mortgage rate. If you try to secure a 2-1 buydown without being able to afford the full mortgage rate in 24 months, you’re setting yourself up for disaster.

With the right negotiation and terms, a 2-1 buydown could be extremely beneficial for you as a homebuyer, allowing you more flexibility with your cash flow for the first 24 months of homeownership.

The 2-1 buydown is not your only option as a first-time homeowner or as a homebuyer looking to take advantage of low mortgage rates; there are many types of loan agreements on the market that might help you reach your goals.

The best way to determine whether a 2-1 buydown is right for you is to consult with a loan professional. A consultation will enable you to get a thorough look at your specific financial situation to determine what type of loan makes the most sense for you. To start your journey to homeownership, get in contact with Agave Home Loans for more info.