For those with good credit and the means, it is one of the easiest times in history to get into a new home. But for some, though the market is right, they find they just do not quite qualify for that new home loan. In a situation like this, it is tempting to consider the FHA 2-1 buy down. When a buyer applies for a loan, but doesn’t qualify for it at the current interest rate, the option of a 2-1 buy down is often put on the table. In this case, lenders will allow borrowers to temporarily “buy down” the interest rate on a mortgage. This allows a purchaser to reduce the initial interest rate on their mortgage by 2% the first year, 1% the next year, and 0% every year thereafter. (It is important to note that there is generally a fee in the form of discount points to buy down a mortgage.)
With a 2-1 buy down, the purchaser temporarily lowers their interest rate on a 30-year mortgage. For example, with an interest rate of 4.25%, a buyer would lock into a deal of paying only 2.25% for year one, 3.25% for year two, and back up to 4.25% for years three-30. However, most mortgage professionals generally do not recommend a 2-1 buy down if the borrower is paying for the buy down. This is because the costs that are charged the borrower at closing are generally equal to the savings in lower payment the first two years.
The main disadvantage of buying down a mortgage is that you will have spent cash up front that you might have been able to use elsewhere more advantageously. Some mortgage companies suggest that the lower interest rates that you pay will free up your cash flow to buy other things, such as furnishings. However, you already had that money before you paid it as a lump sum at the beginning of the loan.
Additionally, the basis for a mortgage buy down is an adjustable rate. You will receive a lower rate at the beginning of the buy down period than you will face at the end. Adjustable rates are not altogether bad; in some cases, they grow appropriately with your income and help you afford a more expensive home. However, if not managed properly, adjustable rate mortgages can be very detrimental. If you are planning on reducing a 4.25% interest rate to 2.25% for one year, 3.25% for a second year, and 4.25% on, you will need to be able to make the higher payments once the third year comes along. People who elect adjustable rates always have good plans to make more money and afford the higher payment. But it is crucial to remember, plans do not always come through. There is always the possibility that you will not get that raise or promotion you were counting on to help with the third year payments.
Then, there is the consideration of taxes. Taxes paid on the purchase the first year are generally based solely on the land owned. So for the first year and a half, owners are paying lower taxes. Once the home is taken into account, taxes will soar the second year, and owners may be struggling to catch up. If they are $200 behind the second year, this will get compounded with the following year’s taxes, making it incredibly difficult to stay on track. This coupled with the rising interest payments means some homeowners simply will not be able to afford their home.
For example, let’s consider taxes on a $100,000 30-year mortgage with a 2-1 buy down. Your interest payment for year one will be $382.25 plus $55 (only taking into account the land) in taxes. This comes out to $437.25. Year two will be $435.21 + $55 taxes = $490.21. But say the homeowner was only prepared to pay the first year’s total of $437.25. This means they do not pay $52.96 of their bill for year two. Then year three reaches its highest point of both taxes (as the house will now be taxed) and interest rates. This leaves the homeowner struggling to make the $491.94 payment + $220 taxes + $52.96 left over from year one. The payment of $770.90 would be a huge shock and a hard one to match when the homeowner was used to paying little more than half of that. Bear in mind, anything not paid that year will only follow through to the next year, making it increasingly hard to ever pay in full.
In this situation, it is best to ask the lender to base taxes (from the first year on) on the estimated value of the house and land. This way, the owner knows exactly what they will be getting into and can budget appropriately from the start. If you happen to pay too much, you will simply get it back at the end of the year.
For the reasons I’ve cited above, I simply cannot recommend a 2-1 buy down to any of my clients or prospective clients. It is best to purchase a home at the price and interest rate you know you can afford. This way, you are able to move into your home without the fear (or reality) of losing it after not being able to keep up with payments. This is my advice especially for first-time homebuyers, who are often at the max of their budget.
If you have any questions on FHA loans, rules, or the things I do and do not advise when considering the purchase of a home, give me a call. If you are interested in simply shopping around for some of the beautiful properties in College Station and Bryan, feel free to contact me anytime for expert real estate advice.
Clay Lee – Realtor
Century 21 Beal, Inc.
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