What is a 3-2-1 Buydown?

John Boyd, CFP®
August 7, 2023

In today’s real estate market, high home prices coupled with steep interest rates can often deter potential homebuyers. This scenario has left many aspiring homeowners waiting for a “mortgage/housing bubble” to burst or rates to drop back to around three percent. However, one financing approach exists in the form of a 3-2-1 buydown, a creative financing approach that might just enable you to live in your dream home.

What is a 3-2-1 Buydown Strategy?

A 3-2-1 buydown is designed to reduce the interest rate in the early years of a mortgage. Essentially, this strategy allows the mortgage rate to be “bought down” for the first three years, after which it reverts to the standard rate.

Let’s illustrate this with an example. Assume you have a $500,000 30-year fixed mortgage at seven percent. Under the 3-2-1 buydown strategy, in the first year, your mortgage rate would be four percent, in the second year, it would be five percent, and in the third year, it would be six percent. From the fourth year onward, it would return to the original seven percent rate. This approach can result in significant monthly savings, especially during the first three years.

However, such substantial savings don’t come without a cost. The reduction in the mortgage rate during the initial years needs to be financed, which leads us to the next question: who pays for the buydown?

Financing the 3-2-1 Buydown

There are three primary ways to finance a 3-2-1 buydown:

Buyer’s payment: The buyer could prepay all the interest upfront, adding to the acquisition costs. This method, however, is not cheap and can deter many potential homebuyers.
Builder’s subsidy: In the case of a new home, the builder could potentially provide credits to deploy the 3-2-1 buydown strategy, incentivizing you to purchase the home.
Seller’s finance: The home seller might finance the buydown to make the home more affordable and attractive to potential buyers.

Seller/Builder subsidized buydowns can make the deal seem enticing, but it’s essential to carefully consider a few key factors before moving forward.

Key Considerations of the 3-2-1 Buydown

At its core, a 3-2-1 buydown is a variation of an adjustable-rate mortgage (ARM). Here are three critical considerations to evaluate if this strategy is right for you:

Affordability: Could you afford the mortgage if you were to pay the original interest rate today? If the higher mortgage rate from the fourth year onward would stretch your budget, but you could still manage it, this strategy might be suitable for you.
Income Growth: Do you anticipate a significant increase in your income in the coming years? If you’re in a career where your income is expected to rise, such as a medical professional in residency, a 3-2-1 buydown could be a sound strategy.
Interest Rates Outlook: Do you believe that interest rates will fall in the future? If you think that rates could drop to a more manageable level in the next few years, you could potentially refinance at a lower rate.

Conclusion

In conclusion, a 3-2-1 buydown can be a powerful tool to manage high home prices and interest rates. However, this strategy requires careful planning and consideration. It’s not for everyone, and the stars need to align for it to make sense. But if you find yourself in a position where it applies, it could be a game-changer, enabling you to purchase your dream home even in an expensive market. If you need help budgeting for a home purchase, reach out to use below!

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