October 27, 1999, Revised January 31, 2005, December 12, 2006

A temporary buydown allows borrowers with excess cash but low incomes, to qualify for loans that would otherwise be out of their reach.

Maximum Expense Ratios May Limit Loan Size

Lenders assess the adequacy of income in terms of two ratios that have become standard in the trade. The "housing expense ratio" is the sum of the monthly mortgage payment including mortgage insurance, property taxes and hazard insurance, divided by the borrower's monthly income. The "total expense ratio" is the same except that the expenses also include the borrower's existing debt service obligations. For each of their loan programs, lenders set maximums for these ratios, e.g., 28% and 36%, which are typical.

Using Excess Cash to Reduce Expense Ratios

The maximum ratios are not carved in stone but the burden of proof is on the borrower to make a persuasive case for raising them. If there is no case for raising the maximums, then the borrower’s only option is to reduce expenses, and this requires some additional cash – either from the borrower or a third party.

Excess cash can be used to repay debt. However, this reduces only the total expense ratio. It does not change the housing expense ratio, which could be the limiting factor.

Excess cash can be used to pay points. This reduces the interest rate, which reduces the mortgage payment and both ratios. Paying more points to reduce the rate is sometimes called a "permanent buydown" because the reduced payment holds for the life of the loan. For this reason, the reduction in the payment is not very large.

Excess Cash Can Fund a Temporary Buydown

Finally, the extra cash can be used to fund a temporary buydown, which reduces the payments made by the borrower using one of the formulas described below. Most temporary buydowns are on fixed-rate mortgages, and the description below applies only to them.

Temporary buydowns are the most effective way to reduce both expense ratios because the payment reduction is concentrated in the early years of the loan. The expense ratios used to qualify the borrower are based on the reduced payment made by the borrower in the first month.

To cover the shortfall between the reduced payments made by the borrower and the regular payment received by the lender, cash is withdrawn from a special escrow account set up for that purpose. The total payment received by the lender, consisting of the payment made by the borrower plus the withdrawal from the escrow account, is exactly the same as it would be in the absence of the buydown.

Illustration of Three Temporary Buydowns

The table below illustrates the three most common temporary buydowns. On a 3-2-1 buydown, the mortgage payment in years one, two and three is calculated at rates 3%, 2% and 1%, respectively, below the rate on the loan. On a 2-1 buydown, the payment in years one and two is calculated at rates 2% and 1% below the loan rate. And on a 1-0 buydown, the payment in year one is calculated at 1% below the loan rate. The examples below assume a market interest rate of 7% on a 30-year fixed-rate mortgage of $100,000.

The 3-2-1 buydown involves the largest reduction in the borrower’s payment in the first year, but also requires the largest amount placed in escrow, as shown on the lowest line.

There are a few lenders who will credit the borrower with interest on the buydown account. For example, if you were credited with 4% interest on the 3-2-1 illustrated above, the required deposit to the buydown account would fall from $4586 to $4369.

Fake Temporary Buydowns

Some lenders including yours not only do not pay interest on the buydown account, but dispense with the account altogether, replacing it with additional points equal to the sum of the buydown digits. That is, they charge an additional 6 points for a 3-2-1, 3 points for a 2-1, and 1 point for a 1-0. These charges exceed the escrows required to make the buydown work, as shown in the table. Thus, the required escrow on a 3-2-1 of $4586 at zero interest divided by the $100,000 loan amount is 4.6%, not 6%. This is a ripoff. You should shop for a lender who does not pad the charge in this way.

Tax Status of Temporary Buydowns

A number of readers have asked me about the tax status of temporary buydowns. I don't know whether there is an IRS ruling or not, but I do have an opinion about what the rule ought to be. On a true temporary buydown where there is an escrow account, the borrower should be able to deduct the total interest paid the lender, from his own payment and from the escrow account. This is the same as the deduction on the identical mortgage without the buydown.

On the fake buydown where the lender collects points equal to the sum of the buydown digits, the points should be deductible, like any other points paid on a mortgage. On a purchase transaction, they should be deductible in the year they are paid while on a refinance they should be prorated over the life of the loan. If the lender does not disclose them as points, however, the borrower cannot claim them as points.