Mortgage buydowns are the hot new trend taking over the housing market. Amidst rumors of an impending housing market crash, what are mortgage buydowns and what do they mean for aspiring home-buyers?

Mortgage buydowns are a sort of concession for home sellers looking to sweeten the deal for their potential buyers. In essence, a buydown works by allowing a seller, homebuilder, or even mortgage lender to pay cash upfront in order to temporarily lower the mortgage rates buyers pay.

For example, a 2-1 buydown will lower a buyer’s mortgage rate by 2% from its permanent rate (market rate) for the first year, and then 1% lower for year two, before reverting back to its long-term rate.

The benefit here is clear: buyers get to enjoy a lower-interest mortgage for a few years, and sellers have a way to sweeten the deal to get the property off the market. Lower monthly payments for a few years at the start of a mortgage can come as a saving grace for hopeful homebuyers concerned over initial payments.

As 30-year fixed-rate mortgages have climbed from 3% during the pandemic to their current 6.5% level, the volume of buydowns has skyrocketed. As a result, interest in buydowns has surged as a way to offset the shock of higher lending rates. While typically a practice reserved for homebuilders, elevated mortgages have pushed buydowns into the resale market.

Now, there’s something to be said about the danger of adjustable rate mortgages (ARM). The 2008 housing crash was caused, in part, by the commission of scammy, variable-rate mortgages that skyrocketed after the teaser rate expired. While this isn’t quite a perfect parallel to the ARMS of days past, with whispers of a housing market crash still circulating, what exactly do these buydowns mean for the housing market?

Mortgage Buydowns Surge as Housing Market Slump Steadies

According to a December survey, 75% of homebuilders were paying to lower buyers’ effective mortgage rates, sometimes for the entire length of the loan.

D’Ann Melnick, a DC-based real estate agent, believes buydowns are a way to counter the tightening housing market:

“There have been a lot of buyers sitting on the sidelines waiting for prices to go down or rates to go down… This is a way they can get rid of that payment shock a bit.”

Unfortunately, the implications of widespread buydowns in an already shaky housing market, are as troubling as they are misunderstood.

Leading up to the financial crisis, buydowns were used in a similar, albeit more targeted fashion, to sell mortgages to individuals who couldn’t afford them. In conjunction with NINJA loans (no income, no job, no asset verification), buydowns were used to persuade buyers to jump onto mortgages under the assumption they could refinance or would be making more money a few years down the line. It’s a risky assumption, one that left many mortgage owners in foreclosure when they couldn’t meet their true loan payments. As such, the dangers of buydowns and other ARMs are typically under-appreciated by many of the buyers most likely to accept the loan.

Ted Tozer, a nonresident fellow at the Urban Institute’s Housing Finance Policy Center, believes this closely mirrors what happened in the housing market collapse in 2008.

“You shouldn’t build a program around that assumption,” Tozer continues, “That’s the same kind of thing that happened in 2007 and 2008 … Say you buy a car with that extra monthly income you have from that buydown and then all of the sudden your rates go up and you can’t afford it.”

Housing Headwinds Continue to Pinch Real Estate Market

The housing market remains troubled. Home builders across the board have reported notable declines in home orders, likely a product of the Fed-induced mortgage rate surge. It’s this slowdown that has pushed sellers towards incentives like buydowns, that offer a more reasonable entry point without cutting the listing price.

Unfortunately, it’s hopeful homebuyers who will eventually feel the downside of loan mechanisms like buydowns.

“We’re at this point in the cycle where things may be turning, the builder is trying to push things through, the lender is trying to push things through,” Mark Calabria, a former Director of the Federal Housing Finance Agency, told the Wall Street Journal. “This is the kind of environment where in order to keep the flow going people cut corners.”

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.