Well, it’s mid-November 2022, and the Real Estate market as well as the mortgage market, continue to spiral. Mortgage rates have been above 7% for over a month and well above 6% for several of the last 6 months. It’s a bit of a meltdown.
But no worries, there is a savior in town! The temporary 2-1 buydown mortgage! That’s right, you can now buy a home and have a temporary reprieve from the reality of the new rates for the first two years. Imagine that! Well, at least until the 3rd year when reality hits you in the face.
If you sense a little sarcasm and apprehension about these buydowns, you are correct. I am not a big fan of the scheme. That is not to say that it is not a good tool if used properly, though. As with many things in life, it’s not the tool, it’s what you do with it.
So let’s dive deep into the details of these buydowns that, in some areas, are capturing up to 50% of the market share in home purchases. This should be a concern for many in the business, especially those doling out these little gems. Remember the “big crash” of 2007 or so? Yup, fueled by those Negative Amortization loans that started at 1% for 30 days, then they exploded on people. These buydowns sound a little similar, don’t they? Let’s take a closer look.
What Exactly Is a 2-1 Buydown Mortgage?
With 2-1 buydowns, the borrower pays a subsidized lower rate than the actual note rate (something they don’t really tell you anywhere else) for a couple of years. In essence, the mortgage note, the contract between lender and borrower, is at the higher rate the entire time.
The borrower pays an effective lower rate because of the financial contribution from their own funds, which makes no sense, or from a third party, like the seller or builder. There is an account setup along with the mortgage to essentially take money every month from that subsidy, and apply it to the real payment, so the full payment is made. Sound confusing? It is a little bit, this is why everyone is just “simplifying it” by telling people that they pay a lower rate for a couple of years.
The reality is, the entire payment of the higher mortgage rate is made, just not from your funds. You make the partial payment based on what a lower rate payment would be, and the remainder is paid from the subsidy account that the seller or builder, or momma set up for you. Yes, the buydown subsidy can come from just about anyone to help you pay a lower payment, not a lower rate.
A practical example so we can be clear on what’s happening here: let’s say you face the prospect of buying a house, and the mortgage amount is $500,000, and today’s mortgage rates are 7% for the sake of simplicity. Under a 2-1 buydown structure, the first year you would pay the payment amount of a 5% mortgage, the 2nd year you would pay the payment of a 6% mortgage, and come year 3, AKA reality time, you would now be on your own with no more subsidy and pay the full pop.
Why You Shouldn’t Fall for This Gimmick
There are some clear warning signs against using these buydowns. First, if you can’t afford the real payment, don’t buy the house. Second, punting that reality 2 years down the road is not the answer. Remember, millions of people bought homes with risky mortgages back in 2002 to 2006; they were deferring reality and hoping for the best down the road. “Hope is NOT a plan”. Many had no idea what would happen years ahead, and neither do we now.
Will mortgage rates drop again? Will house prices keep going up? If ANYONE tells you they know the answer, run in the other direction. Anyone with the ability to make those projections would be richer than Zuck and Musk put together. What everyone is doing is speculating at YOUR expense. Real Estate agents have to put food on the table in hard times, and right now, times are hard. They will do anything to stimulate sales, and these buydowns are perfect gimmicks to get buyers into houses. Buyers who may not be ready to face the reality of a higher payment in 3 years.
When It DOES Makes Sense to Use 2-1 Buydowns
As mentioned previously, it is not the tool but what you do with it. There are some perfect opportunities to use the buydown program. If you follow the news, there are many areas where Real Estate prices have been dropping significantly since about June of 2022. These areas have been overvalued for some time due to things like pent-up demand and shortages of inventory. PLUS, when buyers could get a 2.5% mortgage, the price of the house could go up because the purchase of homes is driven by the capacity to make the payment, and the mortgage rate drives that capacity. Low rates, then, can easily cause prices to go up, just as we have seen for years now.
If you happen to be in one of those areas where sales activity and prices are on the decline, you can capitalize on the opportunity. Sellers are willing to make concessions now that they wouldn’t make before. If you see a house you like, and you want to buy it, and can afford the current market rate payment, you can do the following: instead of asking the seller to deeply discount the house because, well, you may be the only buyer, ask for the 2-1 buydown subsidy. You may even be able to get both! A discount on the price and a subsidy for the buydown.
Again, you are doing this not because you can’t afford the current payment but because you are prudently lowering your payment for a couple of years at the expense of the seller. And don’t feel bad about asking, after all the seller is selling you a house that has gone up at 3 or 4 times the regular rate of appreciation. In this case, the seller is giving up some of his artificial gains to help you get a lower payment for a little bit. Again, you need to be prepared and be able to make the note rate payment. Don’t plan on refinancing or selling later on because rates may not get that much better and if home values drop, you may not be able to refinance.
This is just a little perspective on rates: many think anything over 5% is a high rate because we have seen artificially depressed mortgage rates for over a decade. That’s right, the government has been buying trillions of mortgage-backed securities to keep rates low. But they have stopped doing that.
The reality of mortgage rates is that from Jan 2010 to April 2022, just over 10 of the last 50 years, is when we have seen rates below 5%. For 40 of the last 50 years, rates have been above 5%. So don’t count on below 5% even if rates reverse their current course.
It’s a confusing market out there, and you are going to come across advice that may be biased. Be prudent and do your own research, get to the truth of the matter, especially in matters that may not be familiar to you.
The housing market is in a major shift right now. Make sure you don’t speculate on the future but rather make solid choices you can live with for at least the next 5 years.