Adjustable-Rate Mortgages Versus Temporary Buydowns

Rising interest rates are driving buyers out of the US housing market, which is forcing sellers for the first time in years to offer incentives to entice buyers. This could result in lower interest rates for you, at least in the early years of your loan.

According to Mark Fenton, Eastern North Carolina Regional Mortgage Sales Manager for First Citizens Bank, interest rate reduction options that are gaining traction in today's high-interest markets include two options: adjustable-rate mortgages, or ARMs, which are typically offered by traditional mortgage lenders; and temporary interest rate buydowns, which are typically offered as incentives by sellers.

What are ARMs and buydowns?

An ARM offers a rate that's guaranteed to be lower than the initial fixed market rate for a set number of years. For example, in January 2023 a typical ARM rate stood somewhere between 5.5% and 6.16%, while 30-year fixed-rate mortgages started at about 6.5%, according to Forbes. The initial rate on an ARM lasts for a set period of time—usually 5, 7 or 10 years. After that, the interest rate can rise or fall by as much as 2% per year with a fixed-rate index up to a predetermined cap.

Sellers typically offer buydowns as an incentive. They're 30-year fixed rate loans, but the seller offers to prepay some interest to lower a buyer's payments in the early years. For example, a 2-1 buydown would offer payments that are set at 2% below the fixed rate in the first year and 1% below in the second. After that, the loan reverts to the fixed rate for the rest of its 30-year term.

Choosing the best option

If you're faced with a choice between the two, picking the best one depends on several factors, Fenton says. This includes the length of time you expect to stay in your home and, of course, the underlying numbers. The best advice is to shop around.

"We encourage people to speak to at least two or three mortgage lenders, with at least one of them being a bank or credit union, since they tend to have the best ARM rates to compare," he says. "Not all loans are created equal."

Because of competition among home sellers and lenders for a tightening supply of buyers, there could be plenty of options to shop. Existing home sales fell 35% through 2022 as the Federal Reserve's pressure drove mortgage rates to almost 7% at their fall peak, up from about 3.56% in January 2022.

Faced with a shrinking supply of buyers, sellers offered many concessions ranging from cash for repairs to mortgage rate buydowns in 42% of home sales in the fourth quarter of 2022—up from just over 30% a year before.

On the other side of the equation, buyers increasingly looked for alternatives to high fixed-rate loans as the price of money rose. ARMs increased to 12.8% of all mortgage applications in October 2022. This was the highest level since March 2008, as buyers sought ways to reduce their payments in the early years of their loans.

Compare the numbers

Fenton's calculations show that a 2-1 buydown can look good compared to an ARM in the first 2 years. After that, a quality ARM quickly catches up and can become the better deal.

For example, a 2-1 buydown on a $475,000 mortgage created in December 2022 would shave $7,146 off of your annual mortgage payments in the first year and another $3,663 in the second year. The seller would have to pay $10,810 upfront—the full amount of your payment reductions—to give you this benefit. In the third year, your payments would rise to the loan's full 6.5% rate and stay there until the end of the loan.

As a comparison, your savings on an ARM with a 5.625% starting rate that's guaranteed for 10 years would break even with the buydown savings in the sixth year and save you $14,918 more in total payments than the buydown if you hold it for a full 10 years.

Sellers pay nothing for an ARM, Fenton notes. So if you can convince the seller to take $10,810 off of the home price instead of spending it to buy down mortgage payments, you'd start with more equity in the home and your payments would fall far enough to match the savings on the buydown somewhere in the fourth year.

Most people are in a home long enough to garner the benefits of a 10-year ARM but not long enough for the loan to adjust to a higher rate, Fenton notes, so it's important to consider whether your stay will be longer or shorter than the average. In many parts of the country, homeowners typically spend 8 years or less in the homes they buy, and the length of time they keep their initial mortgage may be even less during periods of declining interest rates.

The bottom line

Whichever option you choose, a mortgage will likely be one of the most expensive obligations you'll ever have. Different options have their own benefits and drawbacks, so it's important to factor in your own situation to determine which route could be the least expensive for you.

"No matter how you slice it and dice it, a mortgage is a mortgage," Fenton says. "No one has a magic bullet that works in all cases."