Buydowns and Loan Assumptions Help Home Buyers Bridge Affordability Gap

A short time ago, historically low interest rates and a post pandemic housing boom fueled one of the hottest housing markets in decades. Buyers were scrambling to purchase new homes amongst an inventory shortage that sparked fierce bidding wars. Property values skyrocketed. Today, the market has shifted, but not fully as expected.

As interest rates rose, affordability soon impacted many home buyers and demand declined. At the same time, inventory declined because homeowners who had a low interest rate on their current homes started to reconsider listing their properties due to the cost of buying a new home. However, during this market shift, buyer demand has not fallen as quickly as inventory, so the current market as of mid-2023 is still oddly a “seller’s market,” and the prices of homes have begun to reheat.

Today’s market is the perfect storm for an affordability crisis. It involves a mix of higher home prices, a higher interest rate environment and severely constricted inventory. To address these market dynamics, homebuyers and sellers are once again turning to innovative financing options to make home ownership more affordable.

We don’t speak of the “inventive” financing that brought the industry and economy to the brink back during the Great Financial Crisis, mind you, but rather traditional methods of securing more affordable mortgage payments. Financing options like interest rate buydowns and loan assumptions can help buyers bridge the affordability gap.

The growing popularity of buydowns and assumptions should find many mortgage originators and servicers looking at their current processes and technology to find ways to streamline the additional details required for these types of loans. Many likely have not dealt with buydowns and assumptions for years, so it’s time to prepare for growing volumes.

Interest Rate Buydowns

A popular option to bring down interest rates and mortgage payments for buyers is buydowns. There are two types of interest rate buydowns available: permanent buydowns and temporary buydowns.

Buyers are increasingly using permanent buydowns to bring down their interest rate and monthly mortgage payments. By the middle of 2023, buydowns had become pervasive, and by some estimates, nearly two thirds of recent originations had permanent buydowns associated with them.

Permanent buydowns allow buyers to pay an additional fee at closing to reduce their interest rate for the life of the loan. Each mortgage point paid is equal to 1 percent of the total loan amount and, as a general rule, has historically been associated with shaving roughly a quarter percentage point off the first lien rate. Buyers can typically pay up to three points, depending on how much they want to reduce their interest rate and the lender’s limit. 

Some sellers, mostly homebuilders of new construction homes, offer temporary interest rate buydowns as an incentive to attract buyers and move inventory.  Temporary buydowns are a financing option in which the home seller pays an upfront fee to lower the buyer’s interest rate for a specific timeframe. The buydown lowers the interest rate to a certain percentage, which then increases each year until it returns to the original rate. Some common types of buydowns include:

• The 1-0 buydown reduces the interest rate by 1% for the first year of the loan.
• The 2-1 buydown reduces the interest rate by2% for the first year and 1% the second year.
• The 3-2-1 buydown reduces the interest rate by3% the first year, 2% the second year and 1% the third year.

Most temporary buydowns are paid for by builders or home sellers as a closing cost equal to the buyer’s interest savings. The seller deposits the subsidy amount into a custodial account at closing and the servicer draws from the account every month to make up the difference between the full loan payment and the discounted payment that the buyer pays each month.

Whether buydowns are permanent or temporary, the right technology can help servicers manage buydown terms and streamline the related processes. For example, the MSP® loan servicing system can accommodate five or more subsidy periods to help servicers manage the borrower’s interest rates, changing payment amounts and temporary subsidy funds during the buydown period.

Loan Assumptions

Another popular financing option is loan assumptions, which allow the buyer to take over the seller’s existing mortgage at the interest rate that’s already associated with the contract on the loan.

Conventional mortgages generally cannot be assumed, but loans backed by the federal government (FHA, VA, USDA) are assumable. Conventional adjustable-rate mortgages (ARM) may be assumable under specific conditions. This can help homebuyers who are looking for a lower interest rate without paying points.

Many lenders are also including loan assumptions as part of their loss mitigation strategies. If a homeowner with an assumable mortgage has a hardship, rather than entering default, they may have the option to transfer their mortgage to another buyer who can afford the mortgage payments and prevent foreclosure.

While loan assumptions provide a viable option to address affordability for home buyers, they are typically a manual-intensive process for lenders. Obtaining the current loan status data, entering it into the origination system, performing calculations, providing an accurate amortization schedule, and then updating the servicing system can be time-consuming, tedious tasks.

As demand for loan assumptions grows, lenders should evaluate their current technology to explore ways to simplify the process.

Conclusion – Be Ready!

Both interest rate buydowns and loan assumptions can be great options for homebuyers, sellers and lenders who are looking to make home ownership more affordable in a high interest rate environment. As a result, an increase in these types of loans is expected and both lenders and servicers should prepare their operations.

Now is the time to evaluate whether your business has the processes, technology and knowledge in place to help it manage the growing demand. A good place to start is to talk with your technology provider to learn about how their systems can support buydowns and loan assumptions.