Understanding Buy-Up Rebates in Mortgage Loans

What Is a Buy-Up?

A buy-up is a type of rebate associated with home mortgage loans. It involves the lender offering an upfront cash incentive to the borrower in exchange for accepting a higher interest rate on the loan. Buy-ups are generally more advantageous to the borrower if they expect to resell the purchased property within a short period of time. The cash incentive cannot exceed the settlement costs associated with the loan.

Buy-ups could aid in reducing out-of-pocket settlement costs, but conflicts of interest can arise involving mortgage brokers and loan officers. Borrowers should ask precise questions to ensure transparency.

How Buy-Ups Impact Mortgage Terms

Buy-ups are typically used by mortgage borrowers who wish to reduce their out-of-pocket loan settlement costs. Because the buy-up results in a higher interest rate on the loan, the borrower is effectively borrowing money at that higher rate and using it to pay for some or all of the settlement costs.

Because the higher interest rate applies to the entire balance of the mortgage, opting for a buy-up is generally only economical if the borrower does not intend to hold on to the mortgage for an extended period of time. In these situations, the upfront cash incentive can more than offset the increased interest cost, considering that those interest costs will only be borne for a limited period of time.

Another consideration to be aware of is that buy-ups are also sometimes paid to mortgage brokers. In these situations, the broker can effectively be incentivized to encourage borrowers to accept above-market rates on their mortgage loans, which are also known as yield spread premiums (YSPs). If these buy-up arrangements are not clearly disclosed to the buyer, they can create a conflict of interest between the two parties.

Before 2010, mortgage brokers’ buy-up rebates were often obscured in the loan terms of the mortgages they sold, making it difficult for borrowers to detect when they were paying a YSP on their mortgage loans. Since then, changes in federal guidelines for new loan estimates require that mortgage brokers’ YSPs be clearly disclosed to the buyer.

Despite these improvements, however, the risk of potential conflicts still remains. Specifically, buy-up rebates and other such incentives are also sometimes given to loan officers within the lending institutions themselves. In these circumstances, there may be little practical ability for the borrower to detect whether the rates they pay are affected by these incentives. As a precaution, borrowers should ask careful and direct questions to their loan officers about which, if any, incentive programs are in place in regard to their loan.

Practical Example: Buy-Up in Action

To illustrate, consider a buyer who wishes to secure a $100,000 mortgage. The standard interest rate offered by the bank is 4.50%. However, the buyer wishes to use a buy-up rebate equal to 2.50% of the loan value. In that scenario, the buyer would receive a cash incentive of $2,500 in exchange for accepting a higher than normal interest rate.

Although the exact level of the new interest rate would be subject to negotiation, the typical formula is for each percentage of the rebate to result in a 0.25% increase to the mortgage interest rate. Therefore, in the above example, the 2.50% cash incentive would result in a 0.625% rate increase. The new interest rate would therefore be 5.125%.

The Bottom Line

A buy-up is a mortgage rebate where borrowers get upfront cash by accepting higher interest rates. It can be a good strategic choice if you plan to sell the property quickly because it can offset settlement costs without long-term interest burdens.

Be aware of potential conflicts of interest with mortgage brokers and loan officers who might push buy-ups for incentives. Always ensure any buy-up arrangements are fully disclosed before accepting higher interest terms.