Interest Rate Buy Downs

Developer Buy Downs

Many developers "buy down" the interest rate on the arranged financing for their newly constructed housing units. They offer lower rates as an inducement to purchasers, particularly when market interest rates are high. The developer buys down the interest rate by paying an amount to the purchasers mortgage lender. Essentially they are paying part of the borrowers/purchasers interest for them in advance.

When a property can be purchased with financing at rates better than the market is currently offering it is said to have beneficial financing. Beneficial financing can result when the vendor/builder buys down the interest rate or in cases where there is an assumable first mortgage with a beneficial contract rate.

Calculating the value of the beneficial financing is necessary in order to compare alternative incentives or peg a purchase offer. The calculation is quite simple. The beneficial mortgage is calculated to find the monthly payment and balance at term end, and a mortgage at current market rates is calculated to find the same. The difference between the payments and the balances at maturity is then discounted to a present value at the going market rate. Assume that market interest rates are currently at 8% for a three year term. Your home purchase will require financing in the amount of $100,000. At market rates of 8% you will have a payment of $763/mo. and a balance at maturity in 36 months of $95,655. The builder of the home you wish to purchase has offered a number of incentives. One is a bought down the interest rate on your $100,000 mortgage to 6% for your three year term. The other is to offer an enhanced appliances package valued at $3,000.

The question is which deal to take. The appliance package is pretty easy to value by shopping the items at retail stores. To determine the value of the interest rate buy down the mortgage must be calculated using the bought down rate of 6%. The monthly payment would be reduced to $640 and the balance at maturity would be $94,265.

An interest rate that is 2% lower than current market rates results in a monthly payment that is $123 less each month and a balance at term end, in 36 months, that is $1,390 lower. Summed these savings equal $5,832, however in order to compare the value of these periodic savings in the future with an appliance package received immediately these benefits must be discounted to a present value. The present value of these savings is calculated at $5,044 discounted at the market rate of return of 8%. Now that the $5,044 value of the beneficial financing has been calculated it is possible to compare this offer with the appliance package incentive of $3,000. Deciding which offer to take depends on other consideration as well and may be shaped by non financial reasons.

$100,000 Mortgage Bought down from a market rate of 8% to 6%

Canada Mortgage Beneficial Financing Calculator

Increased Affordability

One of the reasons that rate buy downs are favored by developers and builders is the impact lower rates have on affordability. Buying down the rate means that the developer is effectively increasing the affordability of his residential project to all potential buyers.

Assume that the builder has developed condominium units valued at around $175,000. Any conventional purchaser may require 75% financing in the amount of $131,250. This mortgage amount would result in a monthly payment of $1,002 at the current market interest rates of 8%. The purchaser would have to earn approximately $43,000* in gross income to be able to qualify for a mortgage of this amount in order to purchase the property.

However, if the interest rate is bought down to 6% the monthly payment will be $839.75 for the next three years. The amount of gross income required to qualify for the mortgage at this interest rate is $35,989*. The interest rate buy down reduces the costs of financing this developers product. The developers condos are now affordable to home buyers with more modest income. Equally as important is the fact that more purchasers will be able to qualify for the mortgage because their shelter financial obligations are reduced to fit within the lenders target debt service ratios.

It is interesting to note that the developer would have to reduce the price of the home by $28,296 to $146,704 in order to match the increased affordability of this 2% buydown. At this reduced price the conventional mortgage would be $110,028 at 8% interest for 3 years resulting in a mortgage payment of $839.75.....same as the bought down mortgage payment.

The cost to the developer of increasing affordability, by bringing the mortgage payment to $893.75, is either a price reduction of $28,296 or a buydown cost of $5,044. In most cases the developer can only spend so much. Buying down the interest rate by $5,000 will have a far greater impact on affordability than will a price reduction of $5,000.

In some cases an interest rate buydown can increase or preserve the sale price of the home, or increase the speed of sale, in comparison to alternative and similar properties.

Qualifying at for a mortgage using bought down interest rates. Affordability is not always increased simply by buying down the interest rate. Mortgage lenders are all too aware of the risks of qualifying a borrower based on artificially lowered interest rates. Once the mortgage is up for renewal, in 36 months, the borrower will have to suffer the current market rates. This would mean a rate of 8% or higher if rates had climbed during the 3 year mortgage term. The monthly payments based on this mortgage rate may be unmanageably high for this homeowner placing them at a greater risk of mortgage default. Each mortgage lender treats interest rate buy downs differently. Whether they use the bought down rate and lower mortgage payment when qualifying the borrower for the mortgage depends on several factors. These include the length of the mortgage term, the amount of financing required, the loan to value ratio, the borrowers debt service ratio - with and without the interest rate buy down, and the reasonable potential that the borrowers earnings will increase within the term offsetting the increased mortgage payment. Each lender has their own policies but it is safe to say that all will weigh the interest rate buy down into the mortgage qualification decision if there reasonable cause.

*Assumes a GDSR of 32%, taxes-heating-condos fees equal to 4% of gross income, and other financial obligations no more than10% of gross income. Mortgage lender policies will vary.

Incentives

Interest rate buy downs are recognized by CMHC within their policy guidelines. This means that a low down payment purchaser can also benefit from an interest rate buy down. An interest rate buy down is one of the few incentives that CMHC does not classify entirely as a sweetener.

If a developer was offering a new home entertainment center valued at $5,000 as an incentive to purchase their $100,000 condominium CMHC would adjust the lending value of the home. It must be assumed that the developer gets and gives nothing for free, what they give away in incentives they make up for in a higher sale price. It is also likely that you could forego the home entertainment package and negotiate the purchase price down to $95,000.

Incentives that do not add lasting value to the real property equal to their cost are subtracted from the purchase price. CMHC will assume that you are paying $95,000 for a home and $5,000 for a home entertainment center. As such they will base the maximum financing on a lending value of $95,000. The result, for 5% downers, would be 95% financing of $95,000 rather than $100,000. The purchaser would have to ante up a down payment of $9,750 to buy this $100,000 condo/entertainment package which is a 9.75% down payment.

Given this treatment of incentives by CMHC and their approved lenders most developers offer incentives that improve the value of the property and won't result in a lending value that is a discount to the purchase price. No developer wants to reduce the affordability of their product by increasing the required down payment to include the purchase of an incentive.

CMHC

Most lenders will not recognize a lower than market interest rate for income qualification purposes if the benefit of the lower rate is short term. The lender will require that the rate be bought down for a period of at least a 3 year mortgage term. Some lenders will only recognize a portion of the beneficial financing amount.

Canada Mortgage and Housing Corporation will also recognize interest rate buy downs provided that the following criteria are met.

CMHC permits buying down the fixed rate of an equal payment mortgage loan to a lower level through payment of a lump sum to the Approved Lender.

The Pre bought down interest rate must be consistent with general market conditions.

The post buy down rate may be used for GDS TDS purposes if the buy down extends for at least 3 years.

The maximum amount of the interest rate reduction will be:

Pre bought - down rate (market rates) Maximum reduction recognized
Less than 8%	0%
Equal to 8% but less than 11%	1%
Equal to 11% but less than 14%	2%
Equal to 14% or greater	3%

Therefore if market rates are less than 8% CMHC will not qualify the client using a lower bought down interest rate. If market rates are 8% up to 10.99% CMHC will only recognize a 1% buy down even if the bought down rate is 2% below the market. Mortgage lenders financing non high ratio properties have more liberal criteria and will likely recognize interest rate buy downs at all market rates if the overall risks of the financing can reasonably be determined as satisfactory.