What it means
A buydown does not alter the loan the lender has written; it subsidises the borrower's payments for a set period out of a pot of money paid at closing. In a 3-2-1 structure the subsidy is largest in the first year and shrinks each year until it disappears, so the borrower steps up to the full payment in three stages.
The money usually comes from the seller or a housebuilder as a sales incentive, and sometimes from the buyer's employer or from the buyer directly. For a seller it can be cheaper than cutting the asking price, because a modest escrow deposit buys a dramatic improvement in the advertised monthly payment.
Lenders size the escrow by working out the monthly payment at each reduced rate, subtracting it from the payment at the note rate, and adding up the differences over 36 months. That total is deposited at closing and released month by month, so the lender always receives the full contractual instalment.
The risk sits in the step up. Borrowers must be able to afford the payment at the full note rate, and responsible lenders underwrite on that basis rather than on the discounted first-year figure.
A household that stretches to the year one payment while assuming it can refinance before year four is making a bet on where rates go. Variants include the 2-1 buydown, which helps for two years, and a permanent buydown, where discount points are paid to cut the rate for the whole term.
If the loan is repaid or refinanced early, unused escrow money is normally credited back, though the agreement decides whose money it becomes.
In practice
Real-world examples.
Example
A housebuilder with 40 unsold units offers a 3-2-1 buydown worth about $14,000 per home instead of a $25,000 price cut. The advertised first-year payment is what brings traffic through the show home, so the cheaper incentive does more selling work than the bigger discount.
Example
A relocating executive accepts a 3-2-1 buydown funded by her employer, so her housing costs stay roughly flat while her salary catches up over three years. Her lender still underwrites the mortgage at the full note rate, which keeps the approval honest.
Example
A seller in a slow suburban market agrees to fund a buydown from the sale proceeds rather than drop the price again. The buyer's first-year outgoings fall by $564 a month, which is the difference that finally persuades the household to proceed.
Formula
Calculation
Monthly subsidy in a given year = payment at the note rate - payment at the reduced rate. Total buydown cost = the sum of the monthly subsidies across all 36 months.
A buyer takes a $300,000 mortgage over 30 years at a note rate of 7%. Monthly payments, rounded to the nearest dollar, are $1,996 at 7%, $1,799 at 6%, $1,610 at 5% and $1,432 at 4%. Year 1 is charged at 4%, so the subsidy is $1,996 - $1,432 = $564 a month, which is $564 x 12 = $6,768 for the year. Year 2 at 5% needs $1,996 - $1,610 = $386 a month, or $4,632, and year 3 at 6% needs $1,996 - $1,799 = $197 a month, or $2,364. The escrow deposit is therefore $6,768 + $4,632 + $2,364 = $13,764, and from month 37 the borrower pays the full $1,996 with no help.Case study
Seen in the real world.
Lakeview Timber Homes is an invented company used here as an illustrative example. In the story it finished a development of 30 houses priced at $360,000 just as mortgage rates rose, and sales stalled with 18 units unsold.
The fictional sales director compared two incentives on a $300,000 loan at a 7% note rate. A $25,000 price cut reduced the monthly payment by about $166, while a 3-2-1 buydown costing $13,764 cut the first-year payment by $564 and still let the company hold its headline price for the valuation on the remaining plots.
Lakeview chose the buydown, published the first-year payment in its advertising and sold 14 houses in four months. Its illustrative mistake was failing to explain the step up clearly in writing, so two buyers were surprised by the year two increase, and the company added a signed payment schedule to its sales pack.
Watch out
Common mistakes.
- Thinking the interest rate on the loan itself has been reduced, when only the payment is subsidised and the note rate is unchanged throughout.
- Budgeting around the year one payment and treating the year four step up as a distant problem that future income will solve.
- Assuming the cost is always borne by the seller, when buyers, housebuilders and employers all fund buydowns in practice.
Questions
People also ask.
Who keeps the escrow money if the loan is refinanced in year two?
The unused balance is normally credited against the payoff amount or returned under the terms of the buydown agreement, so that clause is worth reading before signing.
Is a 3-2-1 buydown the same as paying discount points?
No, points reduce the rate permanently for the life of the loan, while a 3-2-1 buydown is a temporary subsidy that lasts 36 months and then stops.
Can a borrower qualify using the reduced first-year payment?
Mainstream underwriting assesses affordability at the full note rate, so the subsidy helps monthly cash flow rather than loan approval.
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