House won't sell? Don't cut price; try buy-down

These days, I hear many complaints from home sellers.

Among them:

"It's been on the market for nine months with nary a nibble"; "I cut the price three times, still hasn't sold". In a buyer's market, sellers not only compete with each other, they are also in competition with builders. But builders have an advantage: They have affiliations with lenders that let them offer financial inducements that most individual home sellers don't know about.

Yet the fact is that there is nothing that builders offer that individual sellers can't match, provided they know how.

Typically, the first thing sellers think about is reducing the price. That often doesn't work, because the price is not the problem. If borrowers are cash- or income-constrained, a price reduction provides little help.

An example: A person has a house listed at $200,000, and lenders will lend 95 percent of that at 6.5 percent on a 30-year fixed-rate mortgage to a qualified borrower.

But the borrower can't come up with the $14,000 in required cash, consisting of a $10,000 down payment plus settlement costs of $4,000.

If the seller cuts the price by 7.5 percent, or $15,000, the cash required from the borrower drops from $14,000 to $12,950, or by a measly $1,050. It makes more sense for the seller to pay the $4,000 in settlement costs, which reduces required cash by $4,000.

Next, let's consider the case of an income-constrained buyer. The income constraint may be imposed by lenders, who set maximum ratios of income to expenses, or the constraint may be self-imposed, based on what buyers believe they can afford.

The $15,000 price decrease, which reduces the loan amount from $190,000 to $175,000, reduces the payment by $90.07, or 7.5 percent. From the seller's perspective, that is not a lot of bang for the buck.

A better option is to pay points to reduce the rate on the buyer's mortgage, retaining the same sale price and loan amount. If the interest rate on the $190,000, 30-year, fixed-rate loan were reduced from 6.5 percent to 5.5 percent, the payment would fall by 10.2 percent. The cost to the seller would be about 4.6 points, or $8,740. This is about 40 percent less than the price reduction needed to reduce the payment by 7.5 percent.

Points paid to reduce the rate are sometimes termed a "permanent buy-down" because the lower rate and payment run for the entire life of the loan. A more powerful way to lower the payment is for the seller to buy down the payment in the early years of the mortgage. This is called a "temporary buy-down" because the payment reduction doesn't last.

On a 3-2-1 buy-down, the mortgage payment in years one, two and three is calculated at rates 3 percent, 2 percent and 1 percent, respectively, below the rate on the loan.

On a 2-1 buy-down, the payment in years one and two is calculated at rates 2 percent and 1 percent below the loan rate. And on a 1-0 buy-down, the payment in year one is at 1 percent below the loan rate.

Using a 2/1 buy-down to illustrate and the same mortgage as before, the payment in year one is calculated at 4.5 percent, or 2 percent below the 6.5 percent paid the lender.

The payment in year one is reduced by 19.8 percent, which is almost twice as large as the reduction with the permanent buy-down. In year two, the payment is reduced by 10.2 percent. And in year three it is back to what it would have been without the buy-down.

The seller's cost is $4,324, which is about half the cost of the permanent buy-down. The $4,324 is placed in an escrow account from which monthly withdrawals are made.

The total payment received by the lender, consisting of the payment made by the borrower plus the withdrawal from the escrow account, is the same as it would be with no buy-down.

Warning: The buy-down cost assumes the seller is not credited with any interest on the buy-down account. Don't fight about that; the interest is reasonable compensation for setting up the arrangement.

But some lenders calculate the buy-down amount on a 2/1 as 3 percent of the loan amount, which would increase the cost to $5,700. (On a 3/2/1, they would charge 6 percent). This is a rip-off, which you can avoid by making your arrangement through an Upfront Mortgage Broker, www.upfrontmortgagebrokers.org. Since their fee is set in advance, they don't profit from any such rip-offs and won't use a lender who practices them.

The writer is professor emeritus of finance at the Wharton School of the University of Pennsylvania: jguttentag@mtgprofessor.com.