This method is so called because someone–often a relative of the buyer but sometimes the home seller or the home builder–advances cash needed to pay part of the initial mortgage interest. In short, the interest rate is reduced, or “bought down,” so the buyer can qualify for a mortgage. Hence the term Buy-Down.
To understand how this works, you must understand that lenders consider a borrower qualified if he or she has the income to meet the first year’s mortgage payment.
Example: Buyer needs $60,000 to buy a new home. His income qualifies him for a mortgage at 10% but the lender is asking 13%. Solution: Builder sets up a three-year buy-down plan. He supplies enough cash to absorb 3% mortgage interest in the first year, 2% the second year, and 1% the third and last year.
The buyer can afford a 10% mortgage in the first year. The lender, who will receive the full 13% interest anyway, agrees to the deal. By the fourth year, the buyer is responsible for the full 13%, and by then he should be able to afford it.
The buy-down is a good way for a parent to help a child buy a home. If the buy-down is financed by the seller or the home builder, it won’t be a free lunch. The buy-down amount will be reflected in a higher purchase price.