Is a 3-2-1 Buydown Mortgage a Good Idea?

Let’s say you’re buying a home and are offered a 3-2-1 buydown mortgage. While you don’t know what exactly that is, your friend Catherine told you it saved her a ton of money on her new home. You might have a lot of questions and are perhaps on the hunt for an article that answers all of them.

If so, you’ve come to the right place. Allow us to explain what a 3-2-1 buydown mortgage is, how you can get one, and the pros and cons of both.

A 3-2-1 buydown mortgage defined

A 3-2-1 buydown mortgage simply means that for the first three years of mortgage financing, your interest rate is reduced. It gets its name from the variable rate of reduction during those first three years: 3% for the first year of financing, 2% for the second, and 1% for the third (and final) year of reduced-rate payments. From the fourth year onwards, you’ll pay the full interest rate. (Keep in mind other methods are available to initially reduce the interest rate as well. For example, a 2-1 mortgage reduces your payment by 2% during the first year and 1% during the second year; a 1-1-1 mortgage reduces your payments by 1% during each of the first three years, but the fundamentals—and risk-benefit analyses—remain the same.)

This mortgage-financing technique is intended to appeal to people looking to buy a home at a high interest rate or in a competitive environment (or for borrowers who expect higher incomes in the future).

Note that 3-2-1 programs differ from adjustable-rate mortgages (ARMs), as the interest rate and monthly payment can change periodically for the life of the loan with the latter whereas the former features a fixed interest rate. And while 3-2-1 buydown programs may also resemble discount points, they differ in that paying discount points can permanently reduce the interest rate on your mortgage.

How a 3-2-1 buydown mortgage works

Let’s say Alex buys a house for $500,000 with a down payment of $100,000. He must then borrow $400,000. Alex considers taking out a 30-year fixed-rate mortgage payment of 7% per year. At those rates, he will pay approximately $2,661 per month until the house is paid off in full.

Alex then hears about 3-2-1 mortgages and ponders whether this is a good idea for him and his family. Due to the reduced interest rate, he’d only pay 4% per year during the first year of his mortgage: which equals $1,910 per month. For the second year, he’d pay 5% ($2,147 per month) and then an annual cost of 6% (or $2,398 per month) for the third and final year of reduced interest rates. (After that, of course, he’d pay the full 7% each year.)

For comparison’s sake, he’d pay $95,761 by the end of the first three years of a regular fixed-rate mortgage; but with a 3-2-1 buydown mortgage, Alex would pay $22,920 the first year, $25,764 the second year, and $28,776 the third year, resulting in a total of $77,460 paid in the first three years.

At first glance, this seems like a great deal. However, banks won’t just give out 3-2-1 (or 2-1 or 1-1-1) mortgages to anyone who wants one. Instead, you need to pay a fee that—you guessed it—will be the same (or about the same) as what you’d save with a 3-2-1 mortgage in the first place.

In our example above, it looks as if Alex would save $18,301 on his total mortgage payment; but for him to procure a 3-2-1 buydown mortgage, he (or someone else—see below) would need to pay a fee that’s $18,301—or suspiciously close to it.

Does the buyer always pay the 3-2-1 buydown fee?

Not necessarily! Sometimes, the seller will pay the fee—either to attract prospective buyers or as a concession to lock down a sale. This includes both private sellers and builders looking to attract home buyers to a new community. On other occasions, however, you’ll need to pay the fee yourself.

Are 3-2-1 buydown mortgages a good idea?

If you’re required to pay the fee yourself, they are generally not a good idea as 3-2-1 programs don’t actually save you money—instead simply creating the illusion of a good deal. Remember: Alex would need to fork over an amount nearly equal to what his savings would be in order to obtain a 3-2-1 mortgage in the first place! 

If the seller pays the fee, however, circumstances are a bit more complicated. This might surprise you; perhaps you’re thinking that if someone else pays the fee, you’re getting free money. While this is true, you can score even more free money another way in some instances.

When seller pays the fee

If you’re buying a new home from a development corporation (and you’re certain you can avoid the hidden traps lurking in this type of mortgage), a 3-2-1 makes more sense.

However, if you're buying a home from a private seller, you may want to think twice. Let’s go back to Alex and assume the seller will pay his $18,301 fee. Yet, there’s another way Alex could go about this (assuming market conditions allow); he and his realtor could approach the seller and ask to take the money off the asking price instead.

That would make the price of the home $471,200 instead. At 7% interest per year and with a 20% down payment, Alex would then pay $30,096 per year (or $2,508 per month).

The benefit of this price reduction—compared to a 3-2-1 mortgage—is that it doesn’t run out. While Alex would in fact pay more than he would initially, he’d pay less annually after the first three years. This is especially helpful if any unexpected expenses arise after this time, such as disasters not covered by insurance.

If you’re wondering why it’s preferable to take an offered 3-2-1 mortgage when buying a new home from a developer, it’s because you (probably) can’t negotiate with this company. After all, they may have a lot of houses to sell and are likely offering this same mortgage type to all of their buyers. You therefore might not enjoy an opportunity to negotiate how you would with a private seller and are thus forced to take whatever you can get.

What if my income grows?

This is one of the most common arguments wielded by those advocating for 3-2-1 mortgages. As for the reasoning, if you (or your partner) are expecting a raise/new (higher-paying) job/current stay-at-home parent to return to work/end of student debt payments/inheritance, then a 3-2-1 mortgage would allow you to buy a home you otherwise couldn’t afford. Sounds like sound logic, right?

Perhaps, but remember that any number of things can happen amidst these circumstances. Your promotion or new job could fall through. You and your partner could have another child unexpectedly, delaying one parent’s return to the workforce. You or your spouse could lose your job.

It’s impossible to predict the future, and if you’re relying on an income increase to afford a 3-2-1 buydown mortgage, you’re buying a house you likely can't afford (it’s that simple!).

While it might work out, this isn’t always the case for everyone and can sometimes even lead to financial ruin.

Having lower initial payments may not always be ideal

Let’s revisit Alex one last time. He goes with the 3-2-1 mortgage option; the seller is paying for it, so it’s a net gain. For the first year of his mortgage, he would pay $22,920—saving $9,012 in the process. What will he do with the extra money?

He could be smart and invest it—after all, it would have been out of his reach anyway. The fact he even has it at all is a bonus! However, we don’t know Alex; we couldn’t tell you how thoughtful he is with his financial planning. He might invest the money or otherwise pour it all into fast cars, luxury travel, fine dining, designer clothes, etc. You’re starting to see the problem here, aren’t you?

By the end of the first year, Alex might find himself in a situation wherein he and his family are living as if their mortgage payment will stay at $1,910/year forever. This is a pretty big problem, because it’s simply not true—his mortgage payments will in fact rise, year by year, until he hits the full 7% rate at the onset of the fourth year. If Alex doesn’t budget for this impending increase, he could potentially find himself in some very hot water come Year 4—perhaps even defaulting on his mortgage. No one wants that to happen!

In sum: 3-2-1 buydown mortgages

So, in response to the title of this article (“Is a 3-2-1 Buydown Mortgage a Good Idea?”), the answer is probably not.

If you’re paying the fee yourself, you won’t save any money by taking a 3-2-1 mortgage—and might even inadvertently put yourself in a situation wherein you develop dangerous spending habits, so buyer beware.

If the seller is covering the fee, however, then this type of mortgage is likely a good idea—especially if you’re unable to negotiate the purchase price down any further. However, be sure to keep your spending in check; the money you’re saving will have vanished once you reach the fourth year of your mortgage, and you don’t want to encounter the same fate as our fictional character Alex.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.