What is a Buydown, 3-2-1 Buydown, 2-1 buydown and 1-0 buydown?

  A buydown can be very beneficial to somebody looking for a big loan but won’t have the money to make the monthly payments for a few years. It is fairly simple. Basically, it provides a way to lower the interest rate on your home loan temporarily. The way buydowns work is when somebody takes out a mortgage they can pay points to “buy down” the interest rate. One way to look at it is prepaying interest. Now, in order to buy down the interest, a lump sum is paid and set into an escrow account, which, in turn, is used to supplement the borrowers monthly payments. The seller of the house usually pays for this lump sum as a financial incentive for somebody to buy their property. Sometimes the lender will pay the lump sum; this is known as a “lender funded buydown.” The reason a lender would provide the lump sum is usually because they make the note rate on the buydown higher than the market rate. So, once all the buydown adjustments are over with the lender will be making more money off of a higher interest rate. 
 
For Example: If the going interest rate is 7%, the lender might make the note rate at 8%. If you were to get a 3-2-1 buydown, the interest in the first year would be 5%, the second year it would be at 6%, the third year it would be 7%, then every year after that the interest rate would be 8%. 

This is beneficial to both the lender and the borrower. The lender will get all his/her money and most likely more back from the higher interest rate. The borrower, on the other hand, is able to qualify for the loan because of the initial lower interest rate. As stated earlier, it can really help somebody out if they are expecting a higher salary in the next couple of years. That way they can qualify for the bigger loan now and be able to afford it when time requires it. Let’s take a look at the different types of temporary buydowns

• 3-2-1 Buydown – This buydown brings down the interest rate the most. Generally, you pay a total of 6 points to get a 3-2-1 buydown. For the first year the interest rate on your mortgage goes down 3% from the note rate. The second year it comes up to 2% below the note rate. Finally, the third year it comes to 1% below the note rate. After that the interest rate stays at the note rate for the remainder of the loan. A 3-2-1 buydown requires a larger lump sum than the other two to supplement your monthly payments over a longer period of time at a lower interest rate.
• 2-1 Buydown - This is similar to the 3-2-1 buydown except during the first year of the loan the interest rate goes down 2% from the note rate. It will then move to 1% below the note rate during the second year. From the third year on, the interest rate will equal note rate. This type of buydown will cost you 3 points. The lump sum required is not as great as for that of a 3-2-1 buydown but greater than that needed for a 1-0 buydown.
• 1-0 Buydown - This is the shortest Temporary Buydown and will bring your interest rate down 1% from the note rate for the first year. Every year afterwards will have an interest rate equal to the note rate. This buydown will cost you 1 point, and it will have the smallest lump sum in the escrow account.

How Do Points Work?

What are points? They are additional, up-front fees, instead of higher interest rates. When money is scarce, lenders routinely charge points, also known by such designations as "loan origination fees," “premium fees,” or "loan discount;” one point equals one percent of the amount borrowed.

How Do Points Qualify as a Tax Deduction?

The key to points being 100 percent deductible in the year of payment, along with your other home-mortgage interest, is that you pay the points to obtain a specific type of loan. It must be a loan to buy, build or improve (as when you add or remodel a room) your main home, that is, your year-round home, as opposed to, say, a second home that you use as a vacation retreat or property for which you charge rent.

What Does the IRS Say About Loan Points?

Here is how the IRS reads the law when you refinance an existing mortgage. Generally, refinancing points are not deductible in full in the year you pay them unless they are paid in connection with the purchase or improvement of a home. This is true even if the new mortgage is secured by your main home. Translation: Refinancers must write points off in dribs and drabs over the life of the loan — divide the points paid by the number of monthly payments to be made over the life of the loan.

To illustrate, you pay $4,000 in points and will make 360 monthly payments on a 30-year mortgage. Your allowable deduction is $11.11 per payment, or a total of $133.33 for 12 payments.

This IRS allocation requirement has been backed up by a 1988 Tax Court decision, though the Eighth Circuit Court of Appeals rejected the allocation rule when points are paid on a long-term mortgage that replaces a short-term loan with a balloon payment.

When refinancing a second time, or if the loan is paid off early, take a deduction in the payoff year for all remaining points not yet deducted.

The law makes it easier for the IRS to check on whether a homeowner properly deducts points. The lender has to report to the IRS the amount of points, other than refinancing points, paid directly by a borrower. The amount must be listed on Form 1098. Like 1099 forms from banks and brokerage firms that report dividend and interest information, 1098 forms are sent to the IRS for use by its computers, which compare 1098 figures with amounts listed as deductions for points on Schedule A of Form 1040.

How About Seller Paid Points?

Other complications kick in when you are the seller and pay points to induce the lender to arrange financing for the buyer. You cannot count the points as interest. But as a selling expense, they reduce the amount of any gain you realize from the sale and are deductible by the buyer, who then must do some paperwork. He or she has to subtract the amount paid from the purchase price in computing the home’s basis — the figure used to determine gain or loss on the sale of an asset.

Are Prepayment Penalties Tax Deductible?

Be mindful of another wrinkle if you prepay the mortgage on a principal residence and are hit with a hefty penalty (a percentage of the unpaid balance) for the privilege of paying it ahead of time. No matter what the lender calls it, that extra charge is fully deductible home mortgage interest.