Arithmetic and Builder Buydowns

They lower the monthly payment

Several days ago, Kevin Erdmann passes along a chart showing that buydowns are much more popular with builders than simply lowering the asking price of the home. He raised the question of why a builder would buy down the interest rate on the homebuyer’s mortgage rather than lower the price of a home. He gave a convoluted answer.

I am old enough to remember the last time builder buydowns were popular, in the early 1980s, so I know the answer. The point is to lower the monthly payment on a 30-year fixed-rate level-payment mortgage.

For example if you had a $100,000 mortgage with an 8 percent interest rate, the monthly payment is $734. If the builder buys down the rate to 7 percent and raises the price of the house by $5000, so that you have a $105,000 mortgage, the monthly payment drops to $699.

When interest rates and inflation are high, the level-payment mortgage is front-loaded in terms of its impact on the buyer. With inflation of, say, 5 percent, the borrower’s income is expected to grow at 5 percent per year. The ratio of your monthly payment to your income starts out high but ends up really low. We used to call this the “payment tilt” problem.

For example, suppose that the monthly payment today is $1000 and your monthly income is $3000. Then the payment/income ratio is 33 percent, which is probably more than you can afford and more than your lender will allow.

But if inflation raises your monthly income by 1/3 over the next five years, then your income will be $4000, and your payment/income ratio will be 25 percent, which is closer to what you can manage. So for most of the thirty years of the mortgage, the monthly payment will be easy to handle. It’s just up front where it gets hard.

One solution is to get away from the standard mortgage. Back around 1980, lenders and economists came up with many different mortgage instruments, each of which allowed for the monthly payment to start relatively low and increase over time. For example, Bob Van Order proposed the Price Level Adjusted Mortgage, where the payment would rise at the rate of inflation.

These mortgage instruments all have the dreaded “neg am,” or negative amortization, meaning that the outstanding principal increases for a while before declining. With the standard 30-year fixed-rate loan, the outstanding principal starts to decline, albeit slowly, right away.

These alternative mortgage instruments mostly did not catch on in the 1980s. Oddly enough, some of them (but not the PLAM) caught on in the early 2000s, when inflation and interest rates were fairly low. Using those instruments, homeowners’ equity declines in the early years of the mortgage, unless house prices are rising. By 2007, house prices stopped rising, and so these alternative mortgages resulted in borrower defaults with heavy losses by the lenders. The Great Financial Crisis ensued.

A builder buydown is a milder way of lowering the monthly payment. Because the builder still uses a standard mortgage, the borrower does not lose equity if house prices stay constant. But the borrower starts out with less equity to begin with. If I put down $10,000 on a $100,000 house with no buydown, I have $10,000 in equity initially. But if I put down $10,000 and the house with a buydown costs $105,000, then if I sold the house right away at market value I would only get $100,000 for it—so I have only $5000 in equity.

When inflation and interest rates are high, the standard fixed-rate mortgage takes some buyers out of the market because they cannot afford the high initial monthly payment. But assuming that inflation will raise their house price and their incomes, they really could afford the house, just with a different mortgage. The builder buydown addresses that problem, which is the reason that buydowns are making an appearance now.

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Why are homebuilder rate buydowns effective?