Do homebuilders have to offer mortgage rate buydowns for the calculations to work? Loaner

If you’ve been home shopping since early 2022, when mortgage rates rose, you’ve probably encountered redemption.

Buydown is used to reduce a buyer’s mortgage rate, either temporarily or permanently.

This can make the mortgage payment cheaper for the first few years of the loan term, or for the entire 30 years.

These buyouts serve as an incentive to purchase a home, even if interest rates and home prices are high.

And homebuilders are banking on them, in part because they don’t want to lower their prices. And maybe because they need to offer to move the product.

Rate cuts are a good thing, but might even be necessary

As mentioned, homebuilders are big on mortgage rate buydowns, offering them in earnest since the 30-year fixed rate began climbing rapidly in early 2022.

Before spring 2022, mortgage rates were near historic lows, but once the Fed ended its mortgage-backed securities (MBS) purchasing program known as QE and began raise the federal funds rate, conditions changed quickly.

The 30-year fixed rate was around 3 at the start of 2022, and quickly increased to around 6% that same summer.

It finally reached 8% before returning to 6%.

At the same time, house prices continued to rise, albeit at a slower pace than before. This has clearly dampened affordability, but homebuilders are not aiming to lower their prices.

They also cannot appear on their inventory as an individual would. They need to move their inventory.

To solve this problem, they tackled the issue of mortgage rates. They did this by offering mortgage rate buydowns.

So if the going rate for a 30-year fixed rate was 7%, they would offer a buyout for the first few years to make it more palatable.

A 3-2-1 joint buyout offers a 3% lower interest rate in the first year, 2% lower in the second year, and 1% lower in the third year.

This means 4%, 5%, 6% and possibly 7% for the remainder of the loan term. While this might attract buyers who could afford the 7% rate, there was a catch.

Borrowers must still qualify for the mortgage at the actual note rate, which in my previous example is 7%.

In other words, if the borrower couldn’t actually afford to purchase the home with a 7% mortgage rate, using the lender’s maximum DTI calculations, they wouldn’t be able to purchase the property.

As such, builders needed to be even more aggressive and ensure that the rating rate was also lower, not just the teaser rate of years 1-3.

Many manufacturers offer combined temporary and permanent rate buyouts

While the savings from a temporary interest rate buydown are a good incentive to buy a home, they are just that.

If you really want to qualify more home buyers, you need to lower the interest rate for the entire term of the loan.

This rating rate is what banks and mortgage lenders use to qualify home buyers. In other words, they can’t use a rate that has only been in effect for a few years.

This could put the borrower in a bind once the rate returns to the higher real rate.

So they qualify them at the actual mortgage rate, somewhat similar to short-term variable rate mortgages, which can also adjust higher once the initial period is over.

Knowing this, homebuilders began offering combined temporary and permanent buyouts to address both the affordability and incentives issue.

Using my same example above, perhaps the builder would offer a 2/1 buyout instead with a permanent buyout attached.

For example:

Year 1: rate of 3.875%
Year 2: rate of 4.875%
Years 3-30: rate of 5.875%

Now, the lender can qualify the borrower at the rate of 5.875%, since this is the highest rate that will be applied over the life of the 30-year loan.

And it could mean the difference between an approved mortgage and one that’s denied.

Lenders Are Required to Use Score Rate for Mortgage Qualifying

Note that Fannie Mae and Freddie Mac require lenders to qualify the borrower at this time.

In the case of a temporary redemption, “the lender must qualify the borrower based on the rate of the notes without taking into account the redemption rate,” according to Fannie Maé.

If it is a permanent buyout, “eligibility is based on the monthly housing expense/income ratio calculated using the monthly payment at the permanent buyout note rate,” according to Freddie Mac.

This could explain why many large home builders today offer temporary buyout AND permanent buyout.

They attract buyers’ interest with the low temporary rate and ensure they qualify for the mortgage with the permanent buyout rate.

By doing so, they can continue to sell off their inventory and ensure that prices do not fall, despite the erosion of affordability.

Homebuilders continue to win despite those 7% mortgage rates. And arguably, homebuyers also get a decent payout.

Just pay attention to that purchase price if you’re buying a newly constructed home to make sure the low rate isn’t baked in.