3-2-1 Buydowns Are NOT “The New Option ARM,” “Impending Doom” or “Smoke & Mirrors”
That Time I Was Accused Of Fraud And Turned In To Regulators
In the early 2000s, I got to know a roofing contractor really well. He was from Mexico and barely spoke English, but he and I became fast friends because he did such amazing work and I sent him dozens of referrals. So, when he wanted to buy a “fixer” on the west side of Alamo, CA (one of CA’s best neighborhoods) for only $880,000, I did everything in my power to get him into that home because I knew how good of a deal it was and what it would do for his family.
The best financing he qualified for was an ARM tied to the 12 Month MTA – a very low and stable index – with an A Paper lender. I also gave him a very low margin and effectively did the loan for free to ensure his rate would always be very low and that he would have no prepayment penalty. To this day, that same loan has probably never seen 5%, and, if he had kept the loan, it would have stayed under 3% for most of the last decade.
I had a buddy (who spoke Spanish) explain to him exactly how the loan worked and tell him to make interest-only payments. I also made sure his actual debt ratios were very low (under 20% at the time) and I had to work extremely hard to make sure his “fixer” passed muster with the underwriters – even helping him with cosmetic repairs.
It was an insane amount of work but well worth it because a month after he moved in, the home was worth at least $1.5 million – and his kids were enrolled in some of California’s best schools.
So – what happened?
In 2009, a real estate agent called me to discuss his loan. She was surfing for listings, and she had convinced my friend he should sell before his rate shot up and the value of his home dropped further. She did not understand his financing at all, and she especially did not understand how low his margin was or how low his rate was and would get. She had, unfortunately, watched numerous news reports about “unscrupulous mortgage brokers,” “predatory loans,” and warnings of housing Armageddon. To be sure, there were many scumbag-mortgage brokers who pushed unsuspecting borrowers into horrible loans, but this was most definitely NOT a bad loan, given how low the rate was and still would be.
The agent would have none of my explanation though because of her naivete and what she saw on the news. So – she accused me of giving him a “predatory loan” and she turned me in to regulators. Fortunately, the regulator did understand loans and he pretty much laughed when I sent him the promissory note and closing statement showing what I made (or didn’t make), and I of course never heard from him again. My attorney had a similar reaction and reminded me that “no good deed ever goes unpunished” in what was the understatement of the year.
What is worse though is that the agent did convince my friend to sell even though he still had lots of equity, and that home would be worth well over $3 million today! And it was all because she refused to learn how the mortgage side of her business really worked.
I tell this long story because we are getting somewhat similar feedback from some agents about the buydown loans I recently blogged about: The Beauty of Buydowns.
Agents are telling us they are “smoke and mirrors,” “they have no benefits,” and “they are the new option ARMs.” But, these agents are again people who simply don’t fully understand buydowns (or mortgage financing), so I want to blog about buydowns again to make sure everyone knows they are most definitely not “smoke and mirrors.”
They are simply a great way for buyers to get a much lower rate and payment at the expense of a motivated seller. And – buyers still end up with today’s market rate in the end.
There is nothing tricky or misleading about them – and that is the main point of this blog.
If readers want more info or an even clearer explanation, Andrei Paduraru, a Senior Manager at JVM, wrote the additional explanation below.
Temporary Buydowns = Escrow Account Created For The Buyer, Not Lender Fees
- Permanent Buydowns (aka points, origination fees, discount points, or lender fees): These are paid to permanently reduce a borrower’s interest rate by compensating a lender up front for the lost “rebate”, or lost commission, from selling a loan that contains a lower interest rate. So, permanent buydowns go directly into the lender’s pocket and can be paid by buyers or sellers. These are the buydowns that most of us are familiar with, and we generally advise buyers not to pay for them.
- Temporary Buydowns: $0 goes to the lender. 100% of the money goes to the buyer. A temporary buydown is literally (and I do mean literally) an escrow account set up by the sellers to pay the buyer’s mortgage down every month.
Note: I can only speak to the way temporary buydowns work at JVM – other banks/lenders may have different products and processes. Also, permanent buydowns can be added on top of temporary buydowns, but this does not change the oil and water relationship between the two. All of the permanent buydown funds go to compensating the lender, and all of the temporary buydown funds go into the buyer’s escrow account.
How Does This Work?
Let’s say a borrower takes out a $500,000 loan with a 7% rate and a 3-2-1 buydown. Their principal and interest payments on the loan (P&I) are $3,327/mo, and the investor who purchases this loan in the secondary market is contractually obligated to receive that full $3,327/mo payment without exception.
In the first year, the buyer only pays $2,387/mo out of their own pocket, and the remaining $939/mo comes out of the “temporary buydown” escrow account the sellers had funded for them at closing. So, $2,387/mo from the buyer + $939/mo from the seller-funded temporary buydown account = $3,327/mo to the investor in the secondary market. So on and so forth for years 2 and 3, too, with increasing amounts from the buyer and decreasing amounts out of the temporary buydown account.
So, the ~$23,000 paid by the seller for the temporary rate buydown sits in an escrow account (similar to how property tax or insurance impounds can sit in an account) and is drawn against every month. And, if the buyer refinances in the 13th month, they will have roughly $11,000 remaining in that escrow account, which will be applied to reducing their principal balance as part of their refinance.
As you can see, none of those temporary buydown funds ever go to a lender and are 100% to the benefit of the buyer.
So why call these escrow accounts “temporary buydowns” and make them so confusing?
The way the seller’s costs and buyer’s payments are calculated is based on the P&I payments at reduced interest rate levels. It also flows off the tongue a bit more smoothly than “seller-funded escrow accounts for the payment of a buyer’s mortgage with a decreasing benefit over time.”
What’s the catch?
The biggest downside is that some buyers may only focus on the year 1 payment and not budget for what the payment will be in years 4 – 30. We combat this by requiring the buyer to qualify at the highest possible payment. In addition, pushing the higher payments farther out gives the buyers time for inflation to help them by inflating their wages, so the higher payment may not feel as painful. And, if rates start dropping (like Jay predicted in this recent blog) they would be able to take advantage of a JVM Free- fi® and get into a lower rate without losing any of the temporary buydown benefits.
If you need any resources to help either your buyers or sellers better understand how to take advantage of these temporary buydowns, our team has a slew of flyers and calculators we are happy to share.
Founder | JVM Lending
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