Swollen inventories and shrinking sales have builders using incentives to drum up business. But a MINI Cooper in the driveway or an upgraded landscaping package may fall short in converting home shoppers to home buyers when rising interest rates have monthly mortgage payments up 15 percent in the last year, according to John Burns Real Estate Consulting. For many buyers, particularly first-time buyers, a payment jump of that size pushes home-ownership out of reach.
In an effort to improve consumer purchasing power, some builders are bringing back mortgage-rate buy downs. First popular in the high–interest rate environment of the late 1970s, a buy down is when a builder strikes a deal between lender and buyer. The buyer receives a discounted interest rate for a set period of time; the builder pays the difference between the lower rate and the market rate.
For example, in a 2-1 mortgage rate type, a common buy down, a buyer pays an interest rate that is two percentage points below market rate for the first year. The second year, the buyer pays a rate one point below market. From the third year on, the buyer pays full market rate.
The initial rate reprieve keeps entry-level buyers from getting squeezed out of the market while also allowing move-up buyers a little wiggle room to sell their current homes. And if builders are sacrificing cash and margins for incentives anyway, an investment in a buy-down program can keep home buyer demand from getting too thin.
A CASE STUDY A 2-1 buy down is integral for navigating Florida's challenging market, says Sue Stewart, president of MHI Mortgage, the mortgage arm of Melbourne, Fla.–based Mercedes Homes.
However, the spin Mercedes puts on the buy down is that it spent $50 million in securing a large forward commitment from a lender, essentially locking in 30-year financing for a lower-than-market interest rate. So, now with interest rates hovering around the 7 percent mark, Mercedes buyers get two years of reduced payments on top of a 30-year fixed mortgage interest rate of 5.875 percent.
And with the 40-year mortgage coming in vogue, Stewart says that Mercedes can extend homeownership to an even larger group of people. “When you do a 2-1 buy down on a 40-year fixed, boy, your home buyers are getting in dirt cheap,” she says.
However, some industry concern exists over whether these types of incentives put people into homeownership who ultimately can't afford it. Stewart rebuffs that notion, saying, “The buy downs we are doing are not high risk.” Because Mercedes buyers are qualified on a fixed-rate loan rather than any teaser rate, they are less likely to default down the road.
Mercedes' incentive combo is expected to push the company to burn through a significant portion of its inventory homes within a target time frame of six months. “It's definitely helped us sell inventory homes, and that's the big kick right now,” Stewart says.
The other benefit has been to create more purchase value for move-up buyers. Not only is it a tough sell to this crowd because they're more than likely sitting on homes with mortgages anchored to interest rates lower than today's rate, but they've also got to sell their current homes. And with contingency sales becoming more of an issue, Stewart says, it “allows [move-up buyers] to make double payments, if necessary” because the buy down gives them two years of lower payments.