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Are Adjustable-Rate Mortgages Going to Replace Mortgage Rate Buydowns?

October 26, 2023

Lately, mortgage rate buydowns have been all the rage as a means to reduce home buying costs.

This could come in the form a temporary or permanent rate buydown.

These reduce the mortgage rate for the first couple years or for the entire loan term, respectively.

And in doing so, make a home purchase a bit more palatable at today’s still-high asking prices.

But is the market about to shift to adjustable-rate mortgages instead?

Home Builders Have Been Selling Homes with Big Rate Buydowns to Make the Math Work

As mentioned, mortgage rate buydowns have been quite popular over the last couple years.

Prior to early 2022, they were absolutely nonexistent because there wasn’t a need. After all, the 30-year fixed averaged about 3% in January 2022.

But things changed in a hurry when the Fed halted QE, started QT, and began raising the fed funds rate feverishly.

Nearly two years later, we’ve got a 30-year fixed mortgage rate close to 8%, or even above that level depending on individual loan attributes.

As rates have skyrocketed, so too has the prevalence of rate buydowns, whether permanent or temporary.

The most common temporary buydown is the 2-1 buydown, which features an interest rate 2% below the note rate in year one and 1% below the note in year two.

Then it reverts to the full note rate. For example, you could receive a temporary buydown of 6% in year one, 7% in year two, then be stuck with a rate of 8% for years 3-30.

Not great unless mortgage rates get way better in a hurry.

But the home builders have been more aggressive, offering permanent mortgage rate buydowns that last the entire loan term, often 30 years.

So instead of a mortgage rate of 7.75%, they might offer a special buydown of 5.99% for the life of the loan. Not too shabby!

Here’s the problem though – as mortgage rates continue to rise higher, the costs of those buydowns increases.

It’s getting to the point where it costs tens of thousands of dollars to offer such markdowns.

I Stumbled Upon a Home Builder Pitching an ARM Instead of a Rate Buydown

$500k Loan Amount 7/6 ARM
30-Year Fixed
Interest Rate 5.875% 7.625%
Monthly Payment $2,957.69 $3,538.97
Monthly Savings $581.28 n/a
Savings @84 months $48,827.52 n/a
Balance @84 months $447,189.47 $459,994.32

Today, while doing my typical mortgage and real estate research that I do, I came across a home builder offering an adjustable-rate mortgage instead of a buydown.

This was surprising, given the recent trend, though historically speaking pretty darn normal.

Why wouldn’t they offer an ARM, which is going to be the much cheaper option for the builder versus a buydown?

Especially if it accomplishes the same objective, lowering the home buyer’s monthly payment.

The reason these haven’t been a thing lately is because ARMs fell out of style and no one was offering them. There may not have been investors for them either.

But with interest rates so much higher now, you’re starting to see more and more ARM stuff pop up.

And this could actually be a much better deal for the home builders. The offer I saw was a 7/6 ARM priced at 5.875%.

Seeing that the going rate for a 30-year fixed is 7.63% right now, per Freddie Mac, it’s nearly a 2% discount in rate.

That should be plenty to get a prospective home buyer off the fence, even if it’s only good for the first 84 months.

To sweeten the deal, for all involved, you can also generally qualify the borrower at the note rate on a hybrid ARM with an initial fixed-rate period of more than five years.

So if there are any debt-to-income ratio (DTI) constraints, those too might be resolved in the process.

In the end, the builder saves money, the borrower qualifies more easily and gets a lower payment, and a home gets sold.

The Borrower Just Has to Keep an Eye on Rates and Stay Refinance-Eligible

The only difference between a permanent buydown and an ARM is the homeowner now has to keep an eye on mortgage rates if they don’t sell by month 84.

At that point, they’d need to look into a rate and term refinance, assuming interest rates were adequately lower.

It’s not always a slam dunk to refi, either because rates didn’t come down or the borrower no longer qualifies for a mortgage.

Perhaps they lost their job or had unsteady income, or their home dropped in value.

These things can happen, jeopardizing a refinance application and turning an ARM on its head.

But between then and now, each payment whittles down their outstanding balance a little bit faster due to the lower interest rate

And they’ve still got a pretty long time to sit on that ~2% lower mortgage rate before a decision needs to be made…

The big question is will mortgage lenders (and borrowers) embrace ARMs again? If so, they’ll return with a force.

(photo: Elvert Barnes)

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