A buydown is the process of paying additional points on the loan to reduce the monthly mortgage. An owner is paying points to “buy down” the interest rate (or prepay the interest).
A lump sum is paid and set into an escrow account which is used to supplement the debtor’s monthly payments. The seller of the property usually pays for this lump sum as a financial incentive for somebody to purchase their property. Sometimes the creditor will pay the lump sum; this is known as a “lender funded buydown.” The reason a creditor would provide the lump sum is because they make the note rate on the buydown higher than the market rate. So once all the buydown adjustments are over, then the creditor will make money off the new (higher) interest rate.
There are typically two specific types – a permanent buydown or a temporary buydown. In a permanent buydown, a sufficient amount of interest is prepaid to lower the rate permanently. In a temporary buydown, only a sufficient interest is paid to lower the payment for the first three years. The most is called 3-2-1, meaning three percent lower the first year, two percent lower the second year, and one percent lower in the third year.