Temporary Buydowns are Back. What Does This Mean for Speeds?

Mortgage buydowns are having a deja-vu moment. Some folks may recall mortgages with teaser rates in the pre-crisis period. Temporary buydowns are similar in concept. Recent declines notwithstanding, mortgage rates are still higher than they have been in years. Housing remains pricey. Would-be home buyers are looking for any help they can get. While on the other hand, with an almost non-existent refi market, mortgage originators are trying to find innovative ways to keep the production machine going. Conditions are ripe for lender and/or builder concessions that will help close the deal.

Enter the humble “temporary” mortgage interest rate buydown. A HousingWire article last month addressed the growing trend. It’s hard to turn on the TV without being bombarded with ads for Rocket Mortgage’s “Inflation Buster” program. Rocket Mortgage doesn’t use the term temporary buydown in its TV spots, but that is what it is.

Buydowns, in general, refer to when a borrower pays “points” upfront to reduce the mortgage rate to a level where they can afford the monthly payment. The mortgage rate has been “bought down” from its original rate for the entire life of the mortgage by paying a lumpsum upfront. Temporary Buydowns, on the other hand, come in various shapes and sizes, but the most common ones are a “2 – 1” (a 2-percent interest rate reduction in the first year and a 1-percent reduction in year two) and a “1 – 0” (a 1-percent interest rate reduction in the first year only). In these situations, the seller, or the builder, or the lender or a combination thereof put-up money to cover the difference in interest rate payments between the original mortgage rate and the reduced mortgage rate. In the 2-1 example above, the mortgage rate is reduced by 2% for the first year and then steps up by 1% in the second year and then steps up by another 1% in the 3^rd year to reach the actual mortgage rate at origination. So, the interest portion of the monthly mortgage payments are “subsidized” for the first two years and then revert to the full monthly payment. Given the inflated rental market, these programs can make purchasing more advantageous than renting (for home seekers trying to decide between the two options). They can also make purchasing a home more affordable (temporarily, at least) for would-be buyers who can’t afford the monthly payment at the prevailing mortgage rate. It essentially buys them time to refinance into a lower rate should interest rates fall over the subsidized time frame or they may be expecting increased income (raises, business revenue) in the future which will allow them to afford the unsubsidized monthly payment.

Temporary buydowns present an interesting situation for prepayment and default modelers. Most borrowers with good credit behave similarly to refinance incentives, barring loan size and refi cost issues. While permanent buydowns tend to exhibit slower speeds when they come in the money by a small amount since the borrower needs to make a cost/benefit decision about recouping the upfront money they put down and the refi costs associated with the new loan. Their breakeven point is going to be lower by 25bps or 50bps from their existing mortgage rate. So, their response to mortgage rates dropping will be slower than borrowers with similar mortgage rates who didn’t pay points upfront. Borrowers with temporary buydowns will be very sensitive to any mortgage rate drops and will refinance at the first opportunity to lock in a lower rate before the “subsidy” expires. Hence, such mortgages are expected to prepay at higher speeds then other counterparts with similar rates. In essence, they behave like ARMs when they approach their reset dates.

When rates stay static or increase, temporary buydowns will behave like their counterparts except when they get close to the reset dates and will see faster speeds. Two factors would contribute to this phenomenon. The most obvious reason is that temporary buydown borrowers will want to refinance into the lowest rate available at the time of reset (perhaps an ARM).  The other possibility is that some of these borrowers may not be able refi because of DTI issues and may default. Such borrowers may also be deemed “weaker credits” because of the subsidy that they received. This increase in defaults would elevate their speeds (increased CBRs) relative to their counterparts.

So, for the reasons mentioned above, temporary buydown mortgages are expected to be the faster one among the same mortgage rate group. In the table below we separate borrowers with the same mortgage rate into 3 groups: 1) those that got a normal mortgage at the prevailing rate and paid no points, 2) those that paid points upfront to get a permanent lower rate and 3) those who got temporary lower rates subsidized by the seller/builder/lender. Obviously, the buydowns occurred in higher rate environments but we are considering 3 borrower groups with the same mortgage rate regardless of how they got that rate. We are assuming that all 3 groups of borrowers currently have a 6% mortgage. We present the expected prepay behavior of all 3 groups in different mortgage rate environments: