A 3-2-1 buydown works by temporarily lowering your mortgage interest rate for the first three years of a fixed-rate loan: three percentage points below the note rate in year one, two points below in year two, and one point below in year three. Starting in year four, you pay the full rate for the rest of the loan term. The discount is funded by a lump sum paid at closing — usually by the seller or builder — that sits in an escrow account and covers the gap between your reduced payment and what the lender is actually owed each month.
The Rate Structure in Numbers
The math is straightforward. Take your note rate and subtract three, then two, then one. If your fixed rate is 7%, you pay 4% in year one, 5% in year two, and 6% in year three. From year four onward, the rate locks at 7% for the remaining loan term.1Federal Housing Finance Agency Office of Inspector General. Temporary Interest Rate Buydowns Dashboard The mortgage itself never changes. It’s a standard fixed-rate loan the entire time. The buydown just determines who covers the discount during those first 36 months.
Here’s what that looks like on a real loan. On a $457,600 mortgage (a $572,000 home with 20% down) at a 7.125% note rate, principal-and-interest breaks down like this:
- Year one at 4.125%: about $2,772 per month
- Year two at 5.125%: about $3,114 per month
- Year three at 6.125%: about $3,476 per month
- Year four and after at 7.125%: about $3,854 per month
That first-year savings runs over $1,000 a month compared to the eventual payment. For a buyer expecting income growth or wanting breathing room while settling into a new home, that early cushion is the whole point of the structure.
Who Pays and How Much It Costs
The buydown fund equals the total dollar gap between the full note-rate payment and each year’s discounted payment, added across all 36 months. Using the example above, year one saves roughly $1,082 per month, year two around $740, and year three about $378. Multiply by twelve months in each year and the escrow deposit lands near $26,400 at closing.
That money usually comes from the seller, builder, or lender as a negotiated concession in the purchase contract. Under Fannie Mae guidelines, the borrower can also fund the buydown directly.2Fannie Mae. ULDD Requirements for Temporary Interest Rate Buydowns VA loans allow veteran-funded buydowns too, though when a seller or builder pays, the contribution counts toward the VA’s 4% seller concession cap.3Department of Veterans Affairs. Temporary Buydowns – VA Home Loans
Seller Concession Limits
When the seller funds the buydown, the amount eats into concession caps that vary by loan program and down payment:
- Conventional (Fannie Mae): 3% of the sale price when LTV exceeds 90%, 6% for LTV between 75.01% and 90%, and 9% at 75% LTV or below.4Fannie Mae. Interested Party Contributions (IPCs)
- FHA: 6% of the sale price, regardless of LTV.5U.S. Department of Housing and Urban Development. What Costs Can a Seller or Other Interested Party Pay on Behalf of the Borrower
- VA: 4% of the reasonable value of the property.3Department of Veterans Affairs. Temporary Buydowns – VA Home Loans
Those caps cover all seller-paid costs, not just the buydown. Closing costs, prepaids, and discount points the seller absorbs all draw from the same pool. On a VA loan, a 4% cap on a $400,000 home leaves only $16,000 in total seller contributions, which may not stretch far enough to fund a full 3-2-1 buydown alongside other closing costs. Running the numbers before signing an offer keeps a deal from falling apart later.
You Still Have to Qualify at the Full Rate
This is the detail that surprises buyers who assume the lower first-year payment makes qualifying easier. It doesn’t. Both Fannie Mae and VA require lenders to underwrite the loan at the full permanent note rate, not the discounted year-one rate.6Fannie Mae. Temporary Interest Rate Buydowns3Department of Veterans Affairs. Temporary Buydowns – VA Home Loans If your income doesn’t support the year-four payment on paper, the buydown won’t rescue the application. VA guidelines do let underwriters treat an active buydown as a compensating factor for borderline files, but it doesn’t override the rate at which you qualify.
On loan eligibility overall, Fannie Mae allows temporary buydowns on fixed-rate mortgages for primary residences and second homes; investment properties are not eligible.6Fannie Mae. Temporary Interest Rate Buydowns VA permits them on all fixed-rate purchase loans.3Department of Veterans Affairs. Temporary Buydowns – VA Home Loans FHA and Freddie Mac allow them under comparable terms. Cash-out refinances and most adjustable-rate mortgages are excluded across programs.
What Happens If You Sell or Refinance Early
Unused buydown funds don’t disappear if you pay the loan off during the three-year subsidy period. On VA loans, any remaining balance in the escrow account must be applied to the outstanding loan balance at payoff.3Department of Veterans Affairs. Temporary Buydowns – VA Home Loans Fannie Mae works the same way: buydown funds aren’t refundable, but they’re credited to the mortgage balance if the loan is paid off early.6Fannie Mae. Temporary Interest Rate Buydowns
Practically, that means an early sale or refinance shrinks your payoff amount by whatever’s left in the escrow account. The seller originally paid that money, so it isn’t extra cash in your pocket, but it does reduce what you owe at closing, which can help if you’re refinancing into a lower permanent rate. If someone assumes your VA loan, the remaining funds stay tied to the original payment schedule instead of being applied as a lump sum.
How This Compares to a 2-1 Buydown and Permanent Points
A 2-1 buydown uses the same mechanism but over two years: two points off in year one, one point off in year two, full rate from year three on. The upfront cost is meaningfully lower because you’re subsidizing fewer months at smaller discounts. If a seller will contribute $15,000 but your 3-2-1 pencils out at $26,000, a 2-1 might be the version that actually fits the concession budget. What you lose is the deeply discounted first year at three points below the note rate.
Permanent discount points are a different trade entirely. One point typically costs 1% of the loan amount and lowers the rate by roughly a quarter point for the life of the loan. On a $400,000 loan at 7%, spending $16,000 (four points) to drop the rate to 6% would save roughly $95,000 in total interest over 30 years. A 3-2-1 buydown costing a similar amount only saves you money in the first three years. Permanent points pay off if you keep the loan long enough to recoup the cost, usually five to eight years. If you expect to sell or refinance sooner, the temporary buydown delivers more of its value up front, where you can use it.
Tax Treatment
When a seller funds the buydown, the IRS generally treats the contribution as a reduction in the home’s purchase price rather than as income to you. The practical effect is a slightly lower cost basis, which could nudge up your taxable gain if you eventually sell for a profit. The primary-residence capital gains exclusion ($250,000 single, $500,000 married filing jointly) absorbs this for most homeowners without any real consequence.7Internal Revenue Service. Down Payment Assistance Programs – Assistance Generally Not Included in Homebuyers Income
On the deduction side, you can generally deduct mortgage interest you actually pay, but interest covered by a subsidy isn’t your expense to deduct. IRS Publication 936 draws that line clearly for mortgage assistance payments: you can’t deduct interest someone else paid on your behalf.8Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction The portion you pay out of pocket each month remains deductible under the usual rules. If the buydown amount is large, running the numbers with a tax professional before closing is worth the cost.