Buy-down loans offer lower interest rates for first few years

Q. I saw an ad in the newspaper for a new-home subdivision. The builder was offering buy-down loans as an incentive for borrowers. What is a buy-down loan?

A. A buy-down loan is a loan that has the interest rate lowered for the first couple of years.

Someone (often the homebuilder) lowers the rate by buying the rate down (paying money up front to the lender).

Or the homebuilder, if he or she is financing the home via the builder's own mortgage company, can simply offer the buy down as an incentive.

For example, if the prevailing interest rate on a 30-year fixed-rate mortgage is at 4½ percent, a builder may get a lender to offer a 2/1 buy-down loan or offer it himself or herself.

In this case, the lender would charge a rate of 3½ percent for the first year, 4 percent for the second year, and 4½ percent for the remaining term of the loan.

The reduced interest rate during the first couple of years will lower the buyer's required monthly payment.

The rates and terms vary by lenders, but that's generally how it works.

Q. Can I get a buy-down loan for an already existing home?

A. Yes. A buy-down loan can be used for any type of property.

Remember though that someone has to buy the interest rate down.

If there is no builder involved, that leaves you and the lender. If you buy the rate down, you will have to come up with extra money at the closing.

This type of buy down is fairly common, as a borrower can choose to pay discount points (one point equals 1 percent of the loan) up front in order to get a lower long-term interest rate.

If the lender pays to buy-down the rate, you may pay a higher permanent interest rate once the buy-down period is over (compared to the current rate you could get on a fixed-rate loan).

In other words, as in the above example, you would benefit the first two years, but could end up paying 5 percent for the remaining 28 years of your mortgage, even if the prevailing rate was 4½ percent.

If you're looking to lower your monthly payment for the first few years of the loan, ask your lender about other programs as well -- like adjustable-rate mortgage (ARM) loans.