If you’ve been shopping for a home since early 2022, when mortgage rates rose higher, you’ve likely come across the sell-off.
The buy-down is used to lower a home buyer’s mortgage rate, either temporarily or permanently.
This can make the mortgage cheaper for the first few years of the loan period or for the entire 30 years.
These buydowns serve as an incentive to buy a home, even though interest rates and home prices are high.
And housebuilders are all in on them, partly because they don’t want to lower their prices. And maybe because they need to offer them to move product.
Course buyouts are good, but may even be necessary
As noted, homebuilders are big on mortgage buybacks and are offering them in earnest since the 30-year rate began rising rapidly in early 2022.
Prior to the spring of 2022, mortgage rates had been near record lows, but when the Fed ended its mortgage-backed securities (MBS) purchase program known as QE and began raising the fed funds rate, things changed quickly.
The 30-year fix was in the 3s to start 2022 and rose quickly to around 6% that summer.
It eventually went as high as 8% before pulling back into the 6s.
Meanwhile, house prices continued to rise, albeit at a slower rate than previously. This clearly dampened affordability, but homebuilders are not in the process of lowering their prices.
They also cannot sit on their inventory like an individual can. They need to move their inventory.
To solve this problem, they tackled the mortgage rate. They did this by offering to buy down mortgage loans.
Major homebuilders like Lennar and DR Horton rely heavily on them via their internal lenders, Lennar Mortgage and DHI Mortgage.
For example, if the going rate for a 30-year fixed rate was 7%, they would offer a buy-down in the first few years to make it more palatable.
A regular 3-2-1 buydown yields an interest rate that is 3% lower in year one, 2% lower in year two and 1% lower in year three.
That means 4%, 5%, 6% and finally 7% for the rest of the loan period. While this could entice home buyers who could afford the 7% rate, there was a catch.
Borrowers must still qualify for the mortgage at the actual note rate, which in my previous example is 7%.
In other words, if the borrower could not actually afford to purchase the home with a 7% mortgage rate, using the lender’s max DTI calculations, they would not be able to purchase the property.
As such, builders had to become even more aggressive and ensure that the note rate was also lower, not just the teaser rate in years 1-3.
Many builders offer combined temporary and permanent buyouts
While the savings from a temporary interest rate buydown are a good incentive to buy a home, they are just that.
If you actually want to qualify more home buyers, you must have the note rate down for the entire loan period.
This note rate is what banks and mortgage lenders use to qualify home buyers. In short, they cannot use a rate that is only in place for a few years.
That can put the borrower in a pickle when the rate rises back to the actual, higher rate.
So they qualify them for the real mortgage rate, something similar to short-term adjustable rate loans, which can also be adjusted higher when the initial period ends.
Knowing this, home builders have started offering combination funds temporary/permanent buyouts to address both the affordability piece and the incentive piece.
Using my same example from above, maybe the builder would offer a 2/1 buydown instead with a permanent buydown attached.
For example:
Year 1: 3.875% rate
Year 2: 4.875% rate
Years 3-30: 5.875% rate
Now the lender can qualify the borrower for 5.875% interest, as this is the highest rate will go during the entire 30-year loan period.
And it can be the difference between an approved mortgage loan and a rejected one.
Lenders are required to use the note rate for mortgage qualification
Note that both Fannie Mae and Freddie Mac require lenders to qualify the borrower for the note rate.
In the event of a temporary buydown, “the lender must qualify the borrower based on the note price without regard to the purchased interest rate,” according to Fannie Mae.
If it’s a permanent buy-down, “qualification is based on the monthly housing cost-to-income ratio calculated using the monthly payment at the permanent buy-down note rate,” according to Freddie Mac.
This may explain why many large home builders today offer the temporary buy-down AND the permanent.
They attract the buyers’ interest with the low temporary interest rate, and ensure that they qualify for the mortgage loan with the permanent buy-down rate.
In the process, they can keep unloading their inventory and ensure prices don’t fall, despite eroding affordability.
Homebuilders keep winning despite these 7% mortgage rates. And no doubt homebuyers get a decent payment too.
Just be aware of that purchase price if you’re buying a newly built home to make sure the low price isn’t baked in.
