Buydown vs. ARM
When purchasing a home, one of the most important decisions a buyer has to make is how to finance it. Two popular options include Adjustable Rate Mortgages (ARM) and mortgage buydowns. While both options can help buyers afford a home, they work differently and have different advantages and disadvantages. In this blog post, we will compare ARM vs buydown and help you understand which option may be best for your unique situation.
What is an ARM?
An Adjustable Rate Mortgage (ARM) is a loan interest type in which the interest rate is not fixed but adjusts periodically based on a benchmark interest rate. The most common type of ARM is a 30-year loan, but it can also be a 15-year loan. With an ARM, the interest rate is fixed for a certain initial period, after which it will adjust periodically depending on the rate at the time of adjustment.
What's in this article?
The initial interest rate on an ARM is typically lower than the rate on a fixed-rate mortgage, making the monthly payments more affordable in the short term. However, the interest rate can go up over time, making the monthly payments unaffordable. ARM is a good option for people who expect their income to increase over time or for people who expect to move or refinance before the interest rate adjusts.
Ready To Take Your Next Step?
What is a buydown?
A buydown is a strategy in which the lender or another party pays a one-time fee at closing to lower the interest rate on the loan. This can make mortgage payments more affordable in the short term. There are temporary buydowns such as the 2-1 buydown, 3-2-1 buydown and permanent buydowns.
A buydown can be financed by the borrower, seller, or builder/developer and can be a good option for people who want to beat down their mortgage payments in the short term, but it is important to understand that the cost of the buydown can be high.
Primary differences between ARM vs. buydown
The primary differences between Adjustable Rate Mortgages (ARM) vs. buydowns are:
- Interest Rate: An ARM has an adjustable interest rate. In contrast, a buydown typically has a fixed interest rate. The interest rate on an ARM can go up or down depending on the rate at the time of adjustment, while a buydown’s interest rate is fixed.
- Monthly payments on an ARM can fluctuate as the interest rate adjusts, while the monthly payments on a buydown remain constant over time.
- Risk: ARM has more risk than a buydown because an ARM’s interest rate can increase over time, making the monthly payments unaffordable in the long term.
- Initial Costs: An ARM typically has lower initial costs, while a buydown may have higher initial costs due to the cost of the buydown fee.
- Suitability: An ARM may be more suitable for borrowers who expect their income to increase over time or for people who expect to move or refinance before the interest rate adjusts. While a buydown may be more suitable for borrowers who want lower mortgage payments in the short-term but can afford the cost of the buydown.
Who should apply for an ARM?
An Adjustable Rate Mortgage (ARM) is a good option for some borrowers, but it may not be suitable for everyone. Here are some situations where an ARM may be a good fit:
- Buyers who expect their income to increase
- Buyers who plan to move or refinance before the interest rate adjusts
- Buyers who want a lower monthly payment
- Buyers who are comfortable with risk
Who should opt for a buydown
A mortgage buydown can be a good option for some borrowers, but it may not be suitable for everyone. Here are some situations where a buydown may be a good fit:
- Buyers who want lower monthly payments in the short term: A buydown can make a mortgage more affordable in the short term by lowering the interest rate. This can be especially helpful for buyers who are tight on budget or have other financial priorities.
- Buyers who expect their income to remain stable: Buyers who expect their income to remain stable over the loan may find a buydown a good option.
- Buyers who plan to keep the property for a long time: The buydown cost can be high; hence a buydown only makes financial sense for buyers who plan to keep the property for a long time. To determine if a buydown makes financial sense, you must calculate the breakeven point. This is the amount of time it will take to recover the cost of the buydown. To calculate the breakeven point, divide the cost of the points by the monthly savings. For example, if you pay $16,000 in points for a $400,000 mortgage to lower your rate from 5% to 4%, and your monthly savings are $237.63, it would take you 67 months (5.5 years) to recoup your costs. A buydown may not be a cost-effective option if you expect to sell or refinance before this point.
- Buyers who are comfortable with the buydown: The costs of a buydown can be high, and buyers need to understand the long-term costs of the buydown and weigh them against the short-term benefits.
How do I know if a buydown is right for me?
Determining whether a mortgage buydown is right depends on your financial situation and future plans. Here are some things to consider when deciding whether a buydown is right for you:
- Short-term vs. long-term affordability: A buydown can make a mortgage more affordable in the short term by lowering the interest rate, but the cost of the buydown can be high. You should consider whether the short-term benefits of a buydown outweigh the costs.
- Your income expectations: If you expect your income to increase over time, you may be able to afford higher monthly mortgage payments in the future, which could make a buydown less necessary.
- Your plans for the property: If you plan to keep the property for a long time, you may recoup the cost of the buydown over time, making it a good option. A buydown may not be the best option if you expect to move or refinance quickly.
- The cost of the buydown: The cost of a buydown can be significant, and it’s important to understand the long-term costs of the buydown and weigh them against the short-term benefits.
- The local markets: Some markets may be more favorable for a buydown, while others may not. It’s best to consult a local professional to determine the local context.
Buydown vs. ARM: Decide with Compass Mortgage
Whether buydown or ARM, the most important thing is finding the smartest, most cost-effective way to own a house or refinance. At Compass Mortgage, we understand the complexities of home financing and are here to help you make an informed decision. Our team of experts can help you explore your options, whether it be a 2-1 Buydown vs. ARM or another type of financing.Plus, we offer our borrowers Get Committed®, a unique program that provides a fully underwritten loan commitment that locks in your interest rate before you even find the property you want to buy. Contact us today and take the first step toward owning your dream home.