Short-term buy-downs, a financing tactic used by many builders to stimulate sales in the face of rising mortgage rates, are soon likely to become more common.
Temporary interest-rate buy-downs are loans in which sellers — mostly home builders — pay lenders to lower their rates for the first two or three years of the loan. They all but disappear from mortgage menus in good times, when rates are relatively low and affordable. But they reappear almost like clockwork when higher rates start to send otherwise qualified buyers to the sidelines.
That hasn’t happened just yet, at least not in any measurable quantity.
Although loan rates have risen from a 31-year low of 6.68 percent, customers are still visiting model homes at a pretty good clip in most places. So most builders have been able to resist pushing the panic button.
But the Federal Reserve Board has vowed to slow down the surging economy, and higher interest rates will be the result. And as loan costs increase, builders will be forced to find ways to counteract the trend.
“Rates aren’t so desperately high just yet,” says Keith Gumbinger of HSH Associates, a Butler, N.J., mortgage information service. “But we’re starting to see (buy-downs) creeping back into the marketplace. Some lenders are out there actively talking them up to builders.”
Actually, buy-downs come in two varieties. In the first, a full-term buy-down, the builder pays to lower the rate over the life of the loan in order to offer more favorable financing than the competition. In the second variety, the builder pays to lower the rate for only as long as he believes is necessary to continue selling houses.
Generally, this kind of buy-down comes in two versions. There’s the 3-2-1 model, in which the rate is bought down to 3 percent below market the first year, 2 percent the second year, and 1 percent the third year. And then there’s the 2-1, which works the same way: 2 percent the first year and 1 percent the second.
Builders don’t particularly like buy-downs, because they are expensive. At current rates, a 3-2-1 buy-down on a $200,000 loan would require a $9,000 cash advance from the builder to the lender.
Worse, most builders swear they don’t recoup the charge by marking up the price of their houses.
“It is absolute fiction that builders pass all this added cost on to consumers,” says one. “The cost comes right off our bottom lines.”
For most builders, then, buy-downs are more of a survival tool than a marketing strategy. For consumers, though, they represent a way to buy a house now rather than waiting for mortgage rates to subside.
Before jumping, however, buyers would be smart to consider their other loan options, especially alternatives that weren’t readily available the last time higher rates slowed sales.
One product that is certainly worthy of attention is the hybrid ARM. Hybrid ARMs are adjustable rate mortgages that start out as fixed-rate loans for a set period of years. Then, after the initial fixed-rate period runs its course, they become fully adjustable loans in which the rate is subject to change on an annual basis.
In other words, the mortgage rate remains the same for whatever initial term you choose.
Three-, five-, seven- and 10-year hybrids are available, but the longer the fixed period, the more expensive the start rate. After the initial period expires, the rate tracks the rate for one-year adjustable mortgages. And every year after that, the rate follows the market. It may rise, fall, or remain the same.
This kind of loan has its drawbacks. By the time the fixed-rate period expires, market rates could have gone out of sight, in which case you might be forced to pay through the nose. But even if rates aren’t that much more expensive, they are still subject to the vagaries of the market.
At the same time, though, rates could come down. And you can always refinance at any time during the fixed or adjustable periods if you want to lock in a rate you can live with.
Refinancing these days is relatively painless and inexpensive. Indeed, if you can handle a slightly higher rate, the lender may be willing to pay most of the freight.
Let’s look at how hybrids stack up against buy-downs for a $200,000 loan. As a reference point, a $200,000 mortgage at the current rate of 8.45 percent for 30 years would cost $1,531 a month for principal and interest:
With a 2-1 buy-down, the start rate would be 6.95 percent and the payment would be $1,324 a month. In the second year, the rate would bump up to 7.95 percent and the payment would rise to $1,456. In the third year, the rate would increase to 8.95 percent and the payment would be $1,594.
The rate and payment never change again if you have a fixed-rate buy-down. But it would be subject to change if it’s an adjustable loan. More important, though, notice that the rate in the third year is one-half percent greater than the rate for the straight fixed-rate loan. In almost all cases, buy-downs end with a higher rate.
With a 3-1 hybrid, the start rate would be 7.62 percent for a monthly payment of $1,414.89. That’s a savings of $1,572 over the initial three-year period.
With a 5-1 hybrid, the beginning rate would be 7.85 percent for a monthly payment of $1,447. Over the first three years, that adds up to a savings of only $420. But over the next two years, you’d save $3,528. And that’s assuming the rate on the buy-down remains the same during that period. If the buy-down is an adjustable — and most are — the rate could be higher and the savings could be even greater.
Better yet, the hybrid doesn’t cost the builder one red cent. And because he doesn’t have to ante up dough for financing, he might be amenable to cutting his price, covering your closing costs or perhaps tossing in that whirlpool tub or fireplace you can’t quite afford.
