Every time you hear about advance purchase loans again, it’s a sure sign that interest rates have risen and the real estate market has slowed down.
A drawdown occurs when the interest rate is “bought down,” that is, with cash to pay a lower interest rate known as a permanent drawdown or “borrowed” in the future with a higher base interest rate as in a temporary reduction. The lower the interest rate, the lower the monthly payment, and the easier it is to qualify for the loan. On the contrary, the lower the interest rate, the more it costs.
The permanent reduction lowers the rate for the life of the loan. It usually costs one point or one percent of the loan amount to buy at a quarter percent interest rate. If the current rate is 6.50%, for example, you can buy it down to 6.25% for about one point.
A temporary reduction is for a short, set period of time. A 2-1 drawdown is most common when the initial interest rate is two percent below the base rate on the note for the first year and then 1 percent below the base for the second year, ending in the base rate of the promissory note for the remainder of the term. An example would be a base note rate of 7.50% with the first year at 5.50%, the second at 6.50%, and ending at 7.50% for the remaining 28 years on a 30-year loan.
It can be purchased with cash and/or a higher base interest rate with income called Yield Spread Premium, also known as YSP, refund or price premium. Think of it as taking advantage of tomorrow’s higher interest rate to get a lower one today.
Why is this important to you as a seller? Increase your pool of qualified buyers for your home. It costs you between one and three points, but it’s part of dealing with a slow market; either lower the price of your house or give more incentives. It’s a popular tactic used by new home builders when the market is weak.
Why is this important to you as a buyer? The reduction subsidizes your monthly payments to allow time for your income to catch up to the annual increase of approximately 7.5% above the prior year’s payment. You can buy the house you want today instead of waiting, or worse yet, buy a lesser house you really didn’t want. You get the added benefit of fixed-rate security by knowing exactly what your monthly payment is at any given time, unlike an adjustable-rate mortgage. Structured correctly, you benefit at the seller’s expense.
Why is a permanent reduction not a good purchase option? One of the main purposes of the reduction is to make more people eligible for more housing. The cost of three points only reduces the interest rate by about ¾ of one percent, the permanent rate of 6.50% drops to 5.75% for example. A temporary purchase using the same scenario would reduce the first year’s interest to 4.50% percent, a full two percent below. It also reduces the monthly payment substantially below the ¾ of one percent drop in rate.
There are different drawdown variations to discuss with your mortgage advisor if you are a buyer or seller. The 3-2-1 buydown works on the same premise as the 2-1 only for a period of three years. A “flex-fixed” buydown has incremental increases every six months. The structuring depends on your credit score and how much you are paying.
If you’re a seller, an experienced mortgage advisor will structure your initial purchase so it doesn’t cost as much, yet broadens your home’s market appeal. It becomes a powerful marketing tool for your real estate agent to sell your house faster. This mortgage advisor will also structure your new home purchase based on your projected net income so that both transactions go smoothly and suit your needs.
For you, the buyer, an initial purchase is a valuable financing option to add to your mortgage arsenal. The buyback and cost should be structured in your formal purchase contract offer. It expands the number of homes you qualify for and, if structured correctly, benefits from a lower monthly down payment and interest rate paid by the seller. By the time the interest rate reaches the highest base rate; you’ll be able to handle the higher monthly payment with your higher future income if rates remain high and/or to refinance if rates go down.
Your mortgage advisor will explain the program, payments and cost in detail in terms you can understand; what it means to you today and in time. Insist on a written parallel mortgage analysis with mortgage software such as The Mortgage Coach, LoanMagic, or a similar mortgage analytics product. If they can’t, you need to find another lender.