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Ask Dr. Don

Breaking down a buy-down mortgage

Dear Dr. Don,
I have an FHA loan for $124,500 at 7.75 percent interest with a 2/1 buy-down. I'm about to start the second year of the loan at 6.75 percent. Since I don't plan on being in the town home for more than five years, should I be considering refinancing? And if so, what should I be looking for in terms of mortgages and points? I'm confused!
Troubled Terry

Dear Terry,
As you know, but some readers may not, an FHA 2/1 buy-down is a mortgage loan where your mortgage payments are based on a reduced interest rate over the first two years.

The interest rate increases by 1 percent on the loan's first and second anniversary dates. After the second anniversary the loan is at its final and permanent interest rate. In your case, the 2/1 buy-down of a 7.75 percent mortgage has an interest rate of 5.75 percent in the first year, and 6.75 percent in the second year.

At the end of the second year the mortgage bumps up to its permanent 7.75 percent rate. This loan program allows buyers to qualify for more expensive homes than they would otherwise and results in lower mortgage payments in the first two years of the loan.

Unless your seller paid for the buy-down, this is a clear case of TANSTAFL -- meaning "There ain't no such thing as a free lunch." The typical buyer would have paid down the rate on this loan by paying points at closing.

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If you've paid for the buy-down upfront then there really wasn't much point in buying the loan down. If the seller paid for the buy-down then it might have been better to arrange a permanent buy-down vs. a short-term buy-down using this loan program. This FHA library article discusses this loan program.

The decision to refinance actually isn't based on the sunk costs associated with the buy-down or who paid for them. The decision to refinance is based on your reduced monthly mortgage payments from the refinancing and the closing costs you'll pay to get the new loan.

For example, if it costs you $3,000 in closing costs, and the monthly reduction in the mortgage payment is $100, then it will take you 30 months, or 2 ½ years to recoup your costs. Bankrate has a refinancing calculator that helps you determine the payback period.

The calculations are a little trickier with your buy-down loan because the mortgage rate and the monthly payment will both change on the second anniversary of the loan. I've used the Bankrate mortgage calculator to put together the following table that should approximate your situation.


Interest rate

Mortgage term

Monthly payment

Beginning loan balance

Existing 2/1 buy-down





First year


30 years



Second year


29 years



Third and remaining years


28 years



Total payments years 2 to 30





Total interest








29 years



Total payments years 2 to 30





Total interest





Estimated closing costs





Monthly payment savings in year 3+





Payback in months





Payback in years





With the assumption that your refinancing rate would equal the second year rate on the 2/1 buy-down, there aren't any savings in your monthly payment until next year. That extends the payback period by 12 months, which is reflected in the payback periods listed in the table.

It's also important for comparison to keep the mortgage maturities the same. That keeps you from counting the reduction in monthly payments associated with extending the loan term as cash savings. What you actually chose for a loan term is up to you.

Whether you should proceed with a refinancing depends on your closing costs and the actual interest rate on the refinancing. Using an FHA streamlined refinancing can reduce the closing costs associated with refinancing your home, but may limit the amount of interest rate savings on the loan. The FHA Library will let you check out this option.

I don't know where interest rates will be a year from now, but the reduced interest rate on your current loan gives you time to consider your options before deciding to refinance. Paying points upfront doesn't make sense if you're not going to be in the house for very long, and financing the closing costs will reduce your equity position when you do sell the home.

-- Posted: Dec. 27, 2001

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See Also
Mortgage Rate Trend Index
80-10-10 plans with jumbo mortgages
CHART:Interest rates over the past 10 years


National Mortgage Rates
Rates may include points.
30 yr fixed mtg 4.06%
15 yr fixed mtg 3.17%
5/1 jumbo ARM 3.54%

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