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3-2-1 Buydown Loans are a time bomb!! Let's take a look.

Chris Wojciechowski

Personally, Chris loves to laugh, spend time with his friends & family on the patio, and exercise daily...

Personally, Chris loves to laugh, spend time with his friends & family on the patio, and exercise daily...

Nov 2 8 minutes read

Every loan type has a user and a need, but you need to do the math. 

A not-so-new loan type has returned to the market for borrowers to consider. All loan types fill a need, and this loan type is resurfacing to fill a need created by interest rates increasing; a need both at the consumer and leading level. The lender needs to originate loans to create revenue to pay their employees and all the rest of their bills. As a result, the lender establishes a loan (product) that might be useful to the consumer, and to some, it will be. Every buyer right now should consider the 3-2-1 Buydown Loans or those like them; 2-1 Buydown, for example, but you should understand them in detail. So let's take a look. 

Understanding How they work

These loans are relatively simple to understand. Like every loan, these have an interest rate based on your qualification and borrowing history. Right now,  published loan interest rates are around 6.875%. Let's use that as our base rate, meaning if you had a traditional loan, it might be a fixed 6.875% interest rate over the term of 30-40 years. With a 3-2-1 loan, the first three years have a reduced interest rate that hugely affects your monthly payment. For example, in the below table, the borrower is purchasing a home at $520,000 on a 30-year term. Each row calculates the difference between a traditional loan payment of $3416.03 to the reduced payment of the 3-2-1 loan. As you can see, in year one, the interest rate is 3% lower at 3.88% in the 3-2-1 loan, making the payments for year one $971.03 cheaper than the traditional loan. Holy cow, that's great. What a saving each month. In year two, that savings dropped to $664.03, then in year three, $340.03. Finally, in year four, the full interest rate has returned, marking the monthly payment of $3416.03. That's a total of $971.03 more than in year one, which is your new payment for the next 30 years! Boom!

YearRateMonthly Principal & Interest Paid by Borrower (3-2-1 Loan)Monthly Principal & Interest at Note Rate (Traditional Loan)Monthly Difference (Savings)

The bomb just went off!

You read that correctly. Your mortgage payment slowly increased $971 per month and that's ok if you are READY, WILLING, and ABLE to cover that new payment as it increases, but if you can't then what? Well, I suspect what is likely being pitched is you can simply refi this loan when the interest rates are lower again and before this new payment hits in full. Well, that's simple enough, just call back your mortgage broker and apply for a refi... I mean you made all your payments so it's just a matter of a phone call and signing a few papers, right?

Refinancing a Loan is Not a click away.

Refinancing a loan is not a matter of clicking a button, and a few parameters are outside your control and very hard to predict! You need to requalify for this loan and pay some fees that can normally be rolled into the loan. First and foremost, what parameters am I speaking of? After all, you did make all your payments. Well, first the bank will need to understand what your loan balance is vs. what your home is worth. An appraisal will almost certainly be required ($700) to determine if your home is worth more than your loan balance. Remember that when your loan is new, your payment is mostly interest! You have paid down the mortgage a bit, but not very much! Your loan balance in this will be well above $500k. What are your predictions for where the home values might be in the next three years? If they drop below your balance, you're done, no refi for you! That $3416.03 payment is your new realty until your home is worth more than the balance, whenever that happens... 

Suppose your home is worth more than your balance; marvelous, on to the next potential roadblock. Has your job(s) situation changed? Has your household income increased or decreased? I hope it has at least stayed the same! If it fell, you could be done. Next, we have a lot of other factors, too; debt to income is a big one. Did you buy a new var while those payments were low? Next are the interest rates...

Interest Rates will surely be lower... 

Not so fast with that thought! There is no and I mean no guarantee of that happing. Let's take a look at history a bit. The below chart is from FRED (Federal Reserve of Economic Data). Yep, that Federal Reserve. This is their chat about all the past interest rates. Take a look. While there are many, many parameters that control or affect interest rates you can see that over the history of interest rates, even a 6.875% loan is very, very low. What if they are higher than 6.875%? No refi for you into a lower payment.

You could be screwed!

If interest rates are higher than your current loan it's very unlikely that you would even start the refinance process and if you can refi the loan then you are locked into your $3416 payment until you can. Are you WILLING and ABLE to make that payment? If that answer is no you're going to have to consider some more creative solutions to make that payment like a second job or jobs (which will not help you refi your loan), bringing in a roommate, or maybe renting the house out completely. If none of these options work, you are looking at a short sale.

Wrapping it up

This is absolutely a loan type that you should consider and do the math on it. If you do see it as your best option then plan for the future. Be READY, WILLING, and ABLE to manage the change. 

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