Buydowns and Rate Locks

The buydown is a mortgage-financing aid in which the homebuyer or another third party (usually the seller or builder) makes subsidizing payments to the lender so that the buyer's interest rate and, therefore, monthly payment are lowered. The lower interest rate can last for the first few years (known as a temporary buydown) or for the full term of the loan. Typically, buydowns last from one- to five years after the loan is closed. One of the more familiar structures is the 3-2-1 buydown, where the interest rate is 3 percent lower than the note rate (the interest rate that the borrower agreed to pay) of the loan for the first year, 2 percent lower during the loan's second year, and 1 percent lower during the third year of the loan, after which the interest rate reverts to the note rate for the remainder of the life of the loan.

Generally, the funds for the subsidizing payments are paid at closing and placed into an escrow account, out of which payments are made to the lender over the time that the buydown is in effect. Although buydown payments are often made by the property seller, the buyer still ultimately pays in the form of a higher purchase price.

A rate lock is exactly what the name implies – it's an option to lock in a quoted rate of interest for a specified period of time after the approval of a loan application. Without the protection of a rate lock the borrower is at the mercy of fluctuating interest rates; the rate that the borrower qualifies for is not guaranteed to be the final interest rate at loan closing. Using a lock-in, the quoted rate at loan approval will be the final rate at the closing table, thereby protecting the borrower against rising market rates. However, if rates should happen to fall between loan approval and closing, the borrower may not be able to take advantage of the lower cost.

In order to remain competitive in the marketplace, many lenders offer 30- to 45-day rate locks free of charge. If the loan will take a longer period of time to close, extended lock-ins are usually available for an additional fee. A float-down provision (which states that if rates fall before the loan closes the borrower will automatically receive the lower interest rate) may also be included for the sake of competitiveness. The borrower should ensure that his or her loan contains this provision.

If a rate lock isn't automatically included with the loan, there are a number of variables that the borrower should consider before deciding on whether to lock the interest rate. For instance, if the borrower doesn't lock and the rate increases, could he or she still qualify for the loan? Of course, in this circumstance, locking the rate would certainly be prudent.

The borrower should also consider if an extended lock-in would be necessary if the loan will take more than sixty days to close. What is the fee associated with this type of rate lock? When is it paid, is it refundable, and under what conditions?

Are interest rates fluctuating, or are they trending upward or downward? The borrower can check several sources before deciding if a lock-in is advisable. Financial indicators such as the federal discount rate (the rate at which banks borrow money from the Federal Reserve), the actions of the Federal Reserve Board (which tightens or loosens the money in circulation), and the ten-year treasury note market (which plays a large part in determining short-term interest rates) should be evaluated. They can be monitored through local newspapers or by online resources such as The Wall Street Journal and Interest.com. International events also play an increasing role in the volatility of U.S. interest rates, and neither should they be overlooked by the borrower. In fact, many lenders advise that if negative world news is occurring, it's probably wise to lock in the interest rate.