These days, I hear many complaints from home sellers. 

”…its been on the market for 9 months with nary a nibble.”
“I cut the price three times, still hasn’t sold.”
"Three other houses on my block are up for sale, so I took mine down.” 

In a buyer’s market, sellers not only compete with each other, they are also in competition with builders. But builders have an advantage: they have affiliations with lenders through whom they offer financial inducements that most individual home sellers don’t know about. Yet the fact is that there is nothing that builders offer that individual home sellers cannot match, provided they know how.  

Typically, the first thing sellers think about doing to make their houses more marketable is reduce the price. Very often, that doesn’t work, because the price is not the problem. If potential borrowers are cash-constrained or income-constrained, a price reduction provides very little help. 

Here is an example. Jones has her house listed at $200,000 and lenders will lend 95% of that at 6.5% on a 30-year fixed-rate mortgage to a borrower with adequate income and good credit. The cash-constrained borrower, however, can’t come up with the $14,000 in required cash, consisting of a $10,000 down payment plus (say) settlement costs of $4,000.

If Jones cuts the sale price by 7.5% or $15,000, the cash required from the borrower drops from $14,000 to $13,250, or by a measly $750. For this potential buyer, it makes far more sense for Jones to pay the $4,000 in settlement costs, which reduces required cash by $4,000.

Next, lets consider the case of an income-constrained buyer. The income constraint may be imposed by lenders, who set maximum ratios of income to expenses. Or the constraint may be self-imposed, based on what buyers believe they can afford.

The $15,000 price decrease, which reduces the loan amount from $190,000 to $175,750, reduces the payment by $90.07, or 7.5%. From the seller’s perspective, that is not a lot of bang for the buck.

A better option is to pay points to reduce the rate on the buyer’s mortgage, retaining the same sale price and loan amount. If the interest rate on the $190,000 30-year fixed-rate loan were reduced from 6.5% to 5.5%, the payment would fall by 10.2%. The cost to the seller would be about 4.6 points, or $8740. This is about 40% less than the price reduction needed to reduce the payment by 7.5%.

[Note: Lenders limit the size of seller contributions, often to 3% of the loan when the down payment is 5%, and 5% when the down payment is 10% or more, as in my example]. 

Points paid to reduce the rate are sometimes termed a “permanent buydown”, because the lower rate and payment run for the entire life of the loan. An even more powerful way to lower the payment is for the seller to buy down the payment in the early years of the mortgage. This is called a “temporary buydown” because the payment reduction doesn’t last.

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.

I will use a 2/1 buydown to illustrate because it is the most common. Using the same mortgage as before, the payment in year one is calculated at 4.5%, which is 2% below the 6.5% rate paid the lender. The payment in year one is reduced by 19.8%, which is almost twice as large as the reduction with the permanent buydown. In year 2, the payment is reduced by 10.2%. And in year 3 it is back to what it would have been without the buydown.

The total cost to the seller is $4324, which is about half the cost of the permanent buydown. The $4324 is placed in an escrow account from which monthly withdrawals are made. 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.

For further information about temporary buydowns, see What Is a Temporary Buydown?

WARNING: The buydown cost assumes the seller is not credited with any interest on the buydown account. Don’t fight about that, the interest is reasonable compensation for setting up the arrangement. But some lenders go beyond that and calculate the buydown amount on a 2/1 as 3 percent of the loan amount, which would increase the cost to $5700. (On a 3/2/1, they would charge 6%). This is a rip-off, which you can avoid by making your arrangement through an Upfront Mortgage Broker. Since their fee to the borrower is set in advance, they don’t profit from any such rip-offs and won’t use a lender who practices them.

Copyright Jack Guttentag 2007