While sellers of existing homes have struggled with rising rates and softening demand, homebuilders have not only survived, but thrived in this market thanks to the use of mortgage rate buydowns, a tool more widely used by builders since their business is selling homes and clearing inventory. Research from the AEI Housing Center found that these buydowns are not only an effective tool to qualify income-constrained buyers and alleviate excess inventory, but they have also allowed builders to forgo home price cuts.
The beginnings of mortgage rate buydowns
Homebuilders had a less-than-ideal beginning as 2022 dawned. After a long period of rate repression, the Federal Reserve began aggressive monetary tightening, which would ultimately send mortgage rates to their highest levels since 2000. As affordability worsened, potential buyers were forced to pull back. Meanwhile, inventory for new homes soared to levels last seen during the Great Financial Crisis as builders worked off the backlog accumulated from the pandemic’s construction boom.
To overcome these headwinds, builders quickly turned to lowering mortgage rates through permanent rate buydowns — a tool last widely used in the early 1980s when the rates exceeded 12%. This phenomenon becomes clearly apparent when compared to existing home sales, for which these buydowns are very rare. As shown in the chart below, existing and new home sales for the 19 largest home builders had roughly the same note rates until January 2022. However, once rates and inventory levels started to rise thereafter, a growing gap emerged between the two series. The gap peaked in November 2022, when the average note rate for new construction sales was one percentage point lower than the rate for existing home sales. As of July 2023, the gap had slightly narrowed to 0.8 ppt.
* Limited to loans with CLTV 76-80 and FICO 720-770 to control for the effect of loan level pricing adjustments.
Note: Data are for 30-year fixed rate primary-owner occupied purchase loans.
Source: AEI Housing Center, www.AEI.org/housing.
Rate buydowns helped builders ride out higher rates
Their ability to effectively utilize buydowns in a high rate environment has provided homebuilders a competitive advantage: Not only are they able to sell more homes, they are also able to sell these homes without cutting prices. According to Census Bureau data, new home sales in September 2023 surged to the highest level since February 2022, while existing home sales plummeted. On top of that, prices for existing home sales had dropped noticeably, while prices for new home sales had slightly accelerated.
Based on AEI Housing Center’s constant-quality home price data, new home sale prices have far outpaced prices for existing homes during the high rate period — a clear trend reversal from the low rate period. From Jan. 2022 to Dec. 2022 (the latest data point available), existing home prices have appreciated by 3%, while new home prices have appreciated 14%.
* Series ends in December 2022 because AVM tends to equal the sale price if the sale date is less than six months prior to the AVM date (June 2023 in this case). This particularly affects new home sales as they have fewer comparable sales.
Source: AEI Housing Center, www.AEI.org/housing.
Permanent rate buydowns through “bulk forward commitments”
Unlike individual home sellers, builders, due to their size and scale, were much better positioned to adapt to the new market conditions. Their use of rate buydowns is facilitated by the use of “bulk forward commitments,” where builders buy large pools of money at lower rates in advance. This can either be done by locking in rates as a hedge or by paying the lender a bulk buydown fee. Helping to absorb the cost of “bulk forward commitments” are builders’ strong profit margins during the housing boom following the pandemic. As we will demonstrate, permanent buydowns can achieve a similar level of affordability at a lower cost and less market impact than a price cut.
The AEI Housing Center’s data clearly reveal the use of large-scale forward commitments through rate bunching at particular points. For example, in November 2022 when the average note rate for existing home sales was at 6.75%, almost 90% of new homes sold by DR Horton had a note rate below 6% with clear bunching at 3.99%, 4.75%, and 4.99%.
Note: Data are for 30-year fixed rate primary-owner occupied purchase loans. Bin width is 0.125.
Source: AEI Housing Center, www.AEI.org/housing.
Why builders prefer rate buydowns over price reductions
There are three distinct reasons for homebuilders’ reliance on rate buydowns.
First, they are far more cost effective than a corresponding price cut. The math is straightforward: Imagine a builder selling a $400,000 home to a buyer making $100,000 a year. Assuming a 30-year fixed rate mortgage of 7% with 20% down payment, the monthly payment would be roughly $2,100. In this case, the total debt-to-income ratio (DTI) would be 51% and would exceed the Fannie Mae or Freddie Mac DTI limit of 50%.
To reduce the DTI to 48%, the builder would need to cut the sale price by 10%. Alternatively, the builder can offer a 1 ppts. permanent rate buydown to 6%. In both cases, the borrower’s monthly payment would drop to $1,900, which allows the borrower to qualify with a DTI below 50%. However, the cost to the builder with the buydown is only 3.2% of the sales price, or one-third of the cost of a price cut (see table). On the other hand, offering free upgrades such as a marble countertop, another strategy commonly used by the builders, does not help bring down the borrower’s DTI at all.
Stylized comparison between a price cut and a mortgage rate buydown
OriginalPrice Cut1 ppt Rate BuydownHome Price$400,000$360,000$400,000% Down Payment20%20%20%Loan Amount$320,000$288,000$320,000Mortgage Rate7%7%6%Monthly Payment$2,129$1,916$1,919Income$100,000$100,000$100,000Total Debt-to-Income Ratio51%48%48%Cost to Builder$0$40,000(10% price cut)$12,800(3.2% of sales price)
Source: AEI Housing Center, www.AEI.org/housing.
Second, AEI Housing Center data reveal another facet of the builders’ buydown strategy: the use of bulk forward commitments as a tool to offer different rates, and ultimately customized “price cuts”, to different borrowers based on their ability to pay — a classic form of price discernment. For example, in November 2022 the average DTI for DR Horton’s FHA borrowers was 50% regardless of their mortgage rate. One would have expected lower DTIs for borrowers with lower rates as monthly mortgage payments and DTIs increase with higher mortgage rates all else equal. This suggests that DR Horton was offering the greatest buydowns to the most income-constrained borrowers in order to qualify more of them for financing.
Finally, by avoiding actual price cuts, the past and future buyers still see the original price as the sales price, with the bought down rate being much harder to discern and quantify.
Conclusion
Builders benefit from economies of scale that bestow them with advantages over individual home sellers during the current challenging market environment. Had builders not used rate buydowns, they may have been forced to slash prices as existing home sellers were forced to do. Meanwhile, the cost of rate buydowns is relatively low. Based on our back-of-the-envelope calculation, the average cost of buydowns for new homes sold between February 2022 and July 2023 is only around 1.3% of the sale price — a relative bargain for builders compared to a 5% price cut.
So far, buydowns seem to have worked well to shield builders from price cuts. However, the home price data end in December 2022 and since then, mortgage rates have risen from 6.5% to nearly 8%. At these higher levels, it remains to be seen if rate buydowns alone are sufficient for builders to avoid price cuts. As of now, the story is mixed: While Evercore reported more builders raising base home prices than lowering them in October 2023, National Association of Home Builders survey data show contrasting trends. Ultimately, one needs to rely on the constant-quality home price data to gauge the comprehensive price trends, which we will continue to track.
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According to the Census Bureau, months’ supply for new homes surged from 5.8 months in January 2022 to 10.1 months in July 2022.
Temporary rate buydowns, where the builder buys down the mortgage rate for only the first one to three years of the loan, is another tool used by the builders, albeit with less prevalence. Since the buydown is temporary, it does not improve borrower eligibility as the loan is underwritten at the permanent, not temporary, rate. According to our data, the share of temporary buydowns peaked in December 2022 at 9% and is back to 3% in July 2023.
The same trend applies to all new home sales, but the 19 largest builders are offering even lower rates, with DR Horton, Lennar and Pulte using rate buydowns most aggressively.
Unlike average home prices, such as the new home sale price from Census Bureau, constant-quality home price appreciation (HPA) is unaffected by the changes in the composition of homes sold and therefore more accurately reflects the home price trend.
See for example: John Burns.
According to Evercore Chart of the Week on April 14, 2023, starting this year, most builders classify rate buydowns as a reduction in selling price (ASP) on the profit and loss statement (P&L).
For this example, we are combining the monthly housing expense and other monthly debt obligations (assumed to be 25% of the borrower’s monthly income) to compute a total DTI.
The estimate is based on new homes sold between February 2022 and July 2023. Data are limited to all FHA loans and conventional loans with CLTV 76-80 and FICO 720-770 to control for the effect of loan level pricing adjustments.
See Evercore Chart of the Week on November 17, 2023.
Sissi Li is senior data and analytics manager at AEI Housing Center.
