Secondary Strategies: Buydowns vs. Float Downs

According to the Mortgage Bankers Association’s (MBA) Purchase Application Payment Index, as of January, the national median monthly mortgage payment had jumped to $2,134, an increase from December’s $2,055. As seen in Chart 2, the National Association of Realtors’ (NAR) Home Affordability Index is sitting at its lowest levels since tracking began in the 1980s.

Though interest rate cuts would improve near-term and long-term affordability for borrowers by lowering costs for lenders and borrowers and likely increasing inventory, the Federal Reserve has signaled that interest rates will stay higher for longer, meaning affordability will remain lower for longer. In an elevated rate environment, mortgage rate reduction tools like buydown mortgages and rate lock float downs can help borrowers overcome near-term affordability barriers. 

However, the use-case for these strategies are distinct. Considerations by investors in the secondary market limit the flexibility for lenders who want to offer these options, but first lenders must understand how the interest rate environment influences these rate-reduction strategies.

Buydown Mortgages

To address the affordability crisis, lenders have introduced temporary buydowns to restore purchasing power to borrowers. A buydown mortgage provides borrowers with lower mortgage rates for a period of one to three years, depending on the product, which lowers borrowers’ monthly payments for that duration.

By way of example, a 2-1 buydown means the mortgage rate is reduced by 2% in the first year of the mortgage and 1% in the second year, before returning to the regular mortgage rate in the third year. The same logic applies to a 3-2-1 buydown, or a 1-0 buydown.

The mechanics of this rate reduction tool are simple: funds made available by the lender, builder, or seller are deposited into an escrow account to replace the reduced payments by the borrower. Lender- and builder-paid buydowns are more popular with borrowers because sellers usually negotiate concessions in the sale price of the property. 

Once the buydown period expires, the borrower is responsible for the full mortgage payment. The lender recoups the interest income lost by lowering the borrower’s initial rate by bumping up the post-buydown period rate. So, a lender may lower a borrower’ mortgage rate from 7% to 6.25% for the first year, after which the borrower will pay 7.25%. In effect, the borrower is selling discount points instead of buying discount points (which entails paying the lost interest up front).

“With the temporary buydowns, I am able to provide the borrower with reduced interest and a reduced payment depending on the purchase price,” explains Brian Woltman, a branch manager with Embrace Home Loans. “The conversation is around refinancing the house in 2-3 years because there is optimism in the market that rates will eventually come down.”

An attractive feature associated with this loan is that any unused escrow funds can be used towards principal pay down by the borrower when refinancing the loan. “We have to be cognizant of circling back with borrowers in a year to hopefully get their payment to a steadier pace,” says Woltman.

Rate Lock Float Downs

Whereas buydown products enter the market to help affordability when rates aren’t expected to drop in the near future, rate lock float downs are a better tool when rates may drop in 60-90 days, or when borrowers want peace of mind in the case of an interest-rate rally during the lock period.

Signaling from the Federal Reserve about higher rates for longer complicates the conversation with borrowers about float downs. However, because the market generally anticipates rate cuts to happen sometime this summer, float downs may be an effective strategy for locking-in borrowers who would otherwise hold out for mortgage rates to officially drop. 

Borrowers purchase the float down option like a mortgage rate insurance policy – they are buying the option to “float down” their locked rate if mortgage rates do decline during the locking period. For this reason, float downs are most effective in conjunction with longer locking periods. 

Like buydowns, the mechanism for offering rate lock float downs is simple: lenders charge an upfront fee that is typically 0.25%-1% of the loan amount. So, buying the float down option for a $400,000 loan would cost the borrower $1,000-$4,000. Depending on the lender, the option “activates” if mortgage rates drop by a set percentage (typically 0.125%-0.25%) during the locking period.

Hedging Rate-Reduced Loans

Over the past few months, the share of buydowns issued by the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, has been increasing, reaching roughly 6%-7% of all issued pools in January. It is a similar story for government-insured issuance (FHA, VA, and USDA), with the share of buydowns increasing to 7.5% in January. 

Chart 3 shows some of the liquid coupons from the latest issuance in Feb 2024.

However, not all loans can be bought down, and those restrictions on buydown mortgages are intended to limit investor risk. Because of these restrictions, not all lenders find it worthwhile to offer buydown options, given the rate environment and lenders’ core borrower base.

For example, all buydown mortgages have to be underwritten to the regular mortgage rate – the rate the borrower will pay at the end of the buydown period. Within the conventional universe, investor loans and cash-out refinance are not eligible for buydowns. Similarly, FHA buydowns are only available for fixed-rate purchase loans. 

Seller buydowns come with their own risks for both the borrower and investors. If mortgage rates remain elevated, or even increase, the borrower will not be able to refinance the loan and their payment will increase at the end of the buydown period. Because many borrowers purchase buydowns with the intention of refinancing after the buydown period ends, investors should understand that prepayment risk is minimal during the buydown period, yet increases substantially after the buydown period ends.

Although the share of buydown loans has risen recently, analysts do not see systemic risks arising from increased issuance so long as the share of new issuance does not exceed 10%.

Complexities associated with hedging float-down loans is a primary reason not every lender offers float down options to borrowers. Typically, float downs require the use of options on U.S. Treasury bonds (Treasuries) or mortgage-backed securities (MBS) to hedge – both of which have their own pros and cons as hedging tools. 

While MBS options perfectly negate the interest-rate risk associated with float-down loans, they are an over-the-counter (OTC) product that requires dealer relationships and substantial minimum trading amounts. Treasury options, on the other hand, allow small trading amounts, but fail to completely offset the interest-rate risk, meaning lenders are still on the hook for the Treasury-Mortgage basis risk – which can be significant in highly volatile environments.