What is a Rate Buydown, and is it Right For You?
You may have heard of a “Buydown” or “Buying Down the Rate” when applying for a loan. In exchange for a mortgage point(s), a lender may offer a lower interest rate. This means a larger lump-sum payment up front is made to get the lowest possible rate.
Even the smallest percentage decrease can make a large difference. The lower you can get your interest rate upfront, the higher your savings over time.
If an investor is buying a $250,000 rental property that rents out for $2500/Month, they’ll want to figure out how to best meet their investment objectives by structuring the right debt on the property.
If the purchase qualifies for 80% LTV = $200K loan amount, and lets say that pricing is 5.29% and 2 points, the purchaser will need $58K cash to close, and their monthly Net Income based on a $1,109.37 P&I payment is $848.97/Month (or $10,187/Year).
A calculation investors commonly use is “Cash on Cash” return. This is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.
Net Income / Cash to Close = $10,187 / $58,000 = 17.56% .
These figures result in a healthy cash on cash return.
But is there any way to increase this further by putting the right loan structure on the property? What if… they buy down the rate by investing an additional 3 points to reduce the rate? This would require additional cash from the borrower in return for a lower monthly payment; but does it make sense?
The investor will need $64K cash to close, and their Net Income based on a $937.62 P&I payment is $1,020.72/Month (or $12,248.60/Year).
Revisiting the cash on cash return calculation, their Net Income / Cash to Close = $12,248.60 / $64,000 = 19.14%. The charts below demonstrate a side by side comparison of terms with and without buying down the rate:
Investing $6000 to buydown the rate to the lowest possible rate of 3.85% reduced the mortgage payment by $2061.01 per year/ $171.75 per month. This creates additional net cash flow.
It will take 2.5 years to recoup the upfront cost needed for the buydown.
The cash on cash return went from 17.56% to 19.14%. Although this is “only” 1.57% more, it is an 8.96% relative increase.
Is buying down your rate the move you should make?
You should have the answer to this question as early on in the loan process as possible.
Some questions to ask yourself:
How long do you plan to keep the mortgage and the property? A rental property is the perfect example where it may make sense to buy down the rate and increase future cash flow if you have a long term hold strategy.
What is the cost to buy down your rate and do you have the cash to do so? Is allocating the cash you have the optimal place to invest it to meet your investment objectives?
How long will it take for you to recoup the upfront cost and break-even? Most rate buy downs take at least 2 years to "pay for themselves"
Decide if the monthly savings support the upfront cost. This is a benefit for the borrowers who are focused on maximizing their cash-on-cash returns.
