The Federal Housing Administration (FHA) offers a 2-1 buydown for new home purchase loans. However, it is not without issues and potential pitfalls. In effect, a buydown allows a borrower to lower their interest rate on their home purchase loan by 2% during the first year and 1% during the second year. Therefore, those who are approved for a loan with an interest rate of 6% may "buydown" the rate to 4% during the first year and to 5% during the second year. However, during the third year, the interest rate would go back up to 6%. This buydown does not come free; in fact, the lender will charge a fee which is equivalent to the interest that would be paid during those two years.
Why would a borrower pay upfront for something they could easily pay over 24 months?
If the seller of a home would pay the fee, the buyer would realize substantial savings. This would be part of a seller concession, and may allow the borrower to be approved for a higher loan amount. In some cases, the lender may waive the fee, or may offer a credit from the lender to the borrower. In fact,
any third party or the actual borrower may contribute to the buydown funds. Additionally, a lower interest rate means a lower debt ratio for the borrower.
Although the buydown does offer a borrower the opportunity to pay less money during the first two years of their mortgage, there are issues that must be considered. First, if the seller is contributing towards the buydown, this reduces the limit on seller contributions. Additionally, buydowns may only be used on fixed rate mortgages. If there is not a reasonable expectation that the borrower's income will increase within 24 months, what could potentially happen is that two years after the loan when the interest rate normalizes, the borrower may have difficulties paying their mortgage.
The underwriting process for 2-1 buydowns is slightly more complicated than that of traditional loans. Underwriters must determine if the borrower has potential to increase their income. This may be done by confirming that the borrower is currently undergoing training, is in school or has a history of advancement at work. Employment history and earnings are not the only criteria that underwriters may use. In fact, if a borrower has outstanding debt, such as that incurred with a car loan that will be paid off before the interest rate increases, this may also help them qualify. Higher down payments may also be of assistance in getting the borrower approved for these buydowns.
Although the idea of being able to pay less interest rate on a home mortgage for the first two years may be appealing, it is important to understand that the same amount must be paid upfront in order to qualify. In addition, if the home buyer has any doubt about their employment. It may not be in their best interest to consider this type of loan. The 2-1 buydown is an excellent option for a home buyer who can talk the seller into picking up the fees. There is a caveat however, the borrower must be certain they are able to deal with the increased interest rate in two years.