Buy-down refers to a reduction in the interest rate of a loan. This reduction is often compensated by a payment made when the loan is taken out, either by the borrower or the lender. This payment, when made by the buyer, is known as buying discount points.
Discount point, also known as origination point or simply point, is the fee paid at the time of borrowing. One discount point is equivalent to one percentage of the loan amount. Buying one point can lower one’s interest rate by about 0.125% over the term of the loan, if it is a permanent buy-down.
Most buy-downs are, however, temporary. The reduction in rate is applicable only for the first few years. 2/1 buy-down refers to a reduction in interest rate for the first two years of the loan. When the reduced rate is applicable for three years, it is known as a 3/2/1 buy-down.
For example, if the interest rate for a loan is 9%, with a 3/2/1 buy down, the rate for the first year is 6%, for the next year it is 7%, and for the third year it is 8%. Subsequently, when the initial three years end, the rate could return to 9%. Buy-downs are available in a variety of forms.
There are numerous reasons why people may choose the buy-down option. One is financial hardship. Loan payments gradually increase when a buy-down is in effect. Another reason is the need to expand the loan for which a borrower could qualify, since the initial monthly payments would be lower. This is, of course, entirely dependent on whether the lender factors in the buy-down ratio when determining the size of the loan.
Tax reductions are also possible due to buy-down. By paying the discount points for a buy-down in the year of the loan closing, a borrower can obtain a tax deduction for that year. The lower interest rate in subsequent years, while reducing tax benefits, results in lower monthly payments.
Buy-downs are not only beneficial for borrowers, but for lenders as well. In the construction industry, buy-downs are offered either temporarily or permanently, with a reduced interest rate throughout the duration of the loan, in order to encourage people to buy more property. In such cases, the lender pays the discount points.
Buy-down is often used for mortgage loans. When considering whether to obtain a permanent buy-down, a borrower should calculate when her savings from the reduced rate would be equivalent to the payment made for the discount points. Whether or not buy-downs are beneficial is entirely dependent on the one who is buying the discount points.