For nearly two years, record-high interest rates have thrown a wrench into the housing market. While interest rates started spiking in the second half of 2022, the housing market didn’t slow down right away. Buyer demand remained surprisingly strong for some time, partly because builders and lenders ramped up their rate buydown offerings.
Rate buydown programs peaked in December 2022, making up 7.6% of Freddie Mac’s funded loans. Many borrowers who took advantage of rate buydowns assumed that interest rates would correct themselves by the time their full mortgage rates set in. Unfortunately, rates remain high as many of these borrowers’ buydowns are about to expire. As of June 2024, the average rate on a 30-year, fixed mortgage is still 7.50%.
So, what does this concerning trend mean for mortgage lenders? And what can you do to protect your portfolio? In this article, we’ll explain rate buydowns in greater detail and explore how to retain your borrowers in the midst of their expirations.
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What Are Rate Buydowns and How Do They Work?
A rate buydown is a program that allows a homebuyer to enjoy a lower interest rate on their mortgage for a temporary period. To access this lower rate, the homebuyer, their seller, or their builder must pay an upfront fee, which is typically placed into an escrow account. This fee is equal to the total savings generated by the discounted rate.
Unlike discount points, rate buydown rate reductions can only last for up to three years. There are several types of rate buydown programs borrowers can enroll in, including:
- 3-2-1 – With a 3-2-1 buydown program, the borrower enjoys reduced interest rates for the first three years of their mortgage. They receive a 3% reduction during the first year, a 2% reduction during the second year, and a 1% reduction during the third year. After that, they must pay their full mortgage rate going forward.
- 2-1 – The 2-1 buydown program is a two-year program where the borrower receives a 2% mortgage rate reduction during the first year and a 1% rate reduction during the second year. It was the most popular program in 2023, comprising two out of three temporary buydowns.
- 1-0 – A 1-0 buydown is a one-year program that grants a borrower a 1% mortgage rate discount before resetting to the original rate.
In order to obtain a rate buydown, borrowers must meet certain criteria. Most notably, they must qualify for their mortgage’s full rate right off the bat, even if they won’t be paying it for the first few years.
Additionally, participating borrowers need to select the right type of mortgage. Rate buydowns are only available for 30-year, fixed mortgages for primary residences. Beyond that, some government-backed mortgages have additional rate buydown requirements.
Benefits of Rate Buydown Programs
Homebuyers may want to take advantage of temporary rate buydowns for the following reasons:
- Their seller or builder is offering to subsidize the rate buydown – In buyers’ markets, sellers and builders may pay their buyers’ rate buydown fees to save them money on their mortgage and encourage a sale. Around 75% of builders used this strategy to make their homes more attractive to buyers in 2022.
- They anticipate an increase in their income over time – Depending on their profession, some homebuyers may be confident that their income will increase in the next few years. If so, a rate buydown can help them ease into their mortgage and enjoy more affordable payments in the meantime.
- They assume interest rates will decrease soon – In high-rate environments, borrowers may enroll in rate buydown programs with the hope that rates will drop by the time their temporary rate reduction expires, allowing them to refinance and secure a permanently lower rate for the remainder of their mortgage. In 2022 and 2023, this was a popular motivator for buyers who took advantage of rate buydown programs.
Rate Buydown Program Example
To showcase the significant savings rate buydowns can have on borrowers’ monthly mortgage payments, let’s take a look at an example. In October 2022, a homebuyer purchased a new home for $500,000. They made a 10% down payment and qualified for a 30-year, fixed mortgage loan of $450,000 with an interest rate of 7%. Their builder offered them the opportunity to enroll in a subsidized 2-1 rate buydown program.
Once enrolled in this program, the borrower’s interest rate, monthly payment, and annual savings looked like this:
- Year 1 (2022):
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- Interest rate: 5%
- Monthly payment: $2,413.44
- Annual savings: $6,939.18
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- Year 2 (2023):
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- Interest rate: 6%
- Monthly payment: $2,695.74
- Annual savings: $3,551.66
- Year 3 (2024):
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- Interest rate: 7%
- Monthly payment: $2,991.71
- Annual savings: $0.00
As you can see, this borrower can enjoy a much roomier monthly budget during the first two years of their mortgage. Better yet, they’ll save a total of $10,490.85 on their home purchase.
The Problem With Rate Buydown Programs
On the surface, rate buydown programs may sound like a no-brainer for borrowers, particularly if their buyer or seller is footing the buydown fee. However, rate buydowns aren’t without their risks. Rate buydown participants may find themselves in financial trouble due to:
- Lifestyle creep – Rate buydowns can reduce borrowers’ monthly mortgage payments by hundreds to thousands of dollars. These borrowers may allocate that money elsewhere during their buydown period. If they fall victim to this lifestyle creep, they may have a hard time affording their higher monthly payments when they eventually set in.
We saw a similar trend unfold in 2023 when the pause on student loan payments was lifted. After adapting to the prolonged forbearance period, many borrowers struggled to pull back on their spending once their student loan payments returned. - Costlier mortgages – The purpose of rate buydowns is to save money, but it doesn’t always pan out that way. In some cases, lenders may give higher interest rates to their borrowers with buydowns than they would otherwise. Freddie Mac’s data from June 2022 to June 2023 showed that borrowers who opted for buydowns received interest rates that were 15 basis points higher, on average.
- Sustained high interest rates – Many rate buydown participants assume that interest rates will be lower after their program’s expiration. Unfortunately, if these borrowers are wrong, they may find themselves in a position where they’re unable to afford their full mortgage payments, increasing their risk of foreclosure and loan fallout. Today, this is the situation that many rate buydown participants find themselves in.
Looking Back on 2008: Is History Repeating Itself?
Today’s troublesome rate buyback predicament isn’t new. While most people primarily attribute the 2008 housing crisis to adjustable-rate mortgages, expired rate buydowns also played a role. Many buyers who purchased homes in 2005 and 2006 with rate buydowns found themselves in financial hot water in 2008 when they expired.
With this in mind, mortgage lenders should take steps to monitor their portfolios of rate buyback participants with extra care this year.
How to Monitor Your Lending Portfolio and Retain Borrowers in 2024
According to a Seeking Alpha economic analysis, an estimated 600,000 to 700,000 homes are facing rate resets soon. If you have these homes in your lending portfolio, you may be facing an increased risk of loan fallout.
While you can’t manage your borrowers’ budgets on their behalf, you can proactively protect your portfolio by employing the right tools. Here are two solutions we recommend at Certified Credit:
- Cascade Alerts – Our continuous credit monitoring solution, Cascade Alerts, can keep a close eye on your borrowers’ credit reports and alert you anytime they show signs of a looming refinance. After you receive a notification about a borrower from Cascade Alerts, you can strategize the best offer to retain their business. For example, you can let them know about your latest refinancing option or explain how your discount point offering can permanently lower their interest rate for the rest of their mortgage term.
- Portfolio Review – Another helpful tool you can use to safeguard your portfolio is Portfolio Review. This innovative tool scans your customer database for potential risks, including increasing inquiries, trending late payments, and rising credit balances. By staying informed on your borrowers’ credit activity, you can promptly address potential risks with your borrowers promptly and offer them timely solutions.
Take The Health Of Your Portfolio Into Your Own Hands With Certified Credit
To sum it up, a notable portion of rate buyback programs are expiring soon. To prevent this trend from affecting your bottom line, you need to be proactive. From Cascade Alerts to Portfolio Review, our solutions can help you stay one step ahead of potential risks and bolster your borrower support strategies.
Want even more cutting-edge workflow optimization tools? At Certified Credit, we have a wide range of mortgage lending solutions, from our customizable credit reports to our growing suite of Cascade Automation.
Don’t wait for rate buybacks to expire! Strengthen your risk mitigation by scheduling your credit consultation with Certified Credit today.
