Rising interest rates have many borrowers seeking ways to manage their cash flow and improve loan terms. One option lenders sometimes offer is a rate buydown, which involves paying up front to secure a lower interest rate. It can be a helpful tool, but only in the right circumstances.
What is a Rate Buydown?
A rate buydown allows a borrower to reduce the interest rate on a commercial real estate loan by paying an additional fee at closing. The cost is usually expressed in “points,” with one point equal to one percent of the loan amount. For example, on a $10 million loan, one point equals $100,000. A lender may reduce the interest rate by 20–30 basis points for each point paid, although the exact tradeoff depends on market conditions.
Permanent buydowns remain in effect for the life of the loan. Temporary buydowns, which are more common in residential mortgages, offer a lower rate for the first one to three years before resetting to a higher rate. In commercial real estate, permanent buydowns are the more typical structure.
When Lenders Offer Buydowns
Not every lender offers buydowns, and those that do may limit them to certain products. They are most common in permanent loans, such as agency multifamily or life company debt, where the term is long enough for the savings to matter. In bridge and construction loans, buydowns are less common but may be available if the lender needs to improve the debt service coverage ratio to make a deal work.
The Buydown Decision Framework
The following factors can help determine whether a buydown aligns with the project’s financing strategy.
A rate buydown makes financial sense when:
- Hold period is 3+ years (preferably 5+)
- Property generates stable, predictable cash flow
- DSCR is borderline and needs improvement to qualify
- The borrower has excess capital after reserves and near-term capital expenditures
- Interest rates are elevated and unlikely to drop significantly
Avoid buydowns when:
- Planning to refinance within 2-3 years
- The property needs significant capital improvements
- Cash reserves are limited
- Considering adjustable-rate debt
- There are higher-return uses for the capital
A simple breakeven analysis shows whether the savings exceed the cost.
Real-World Example: $10M Loan Analysis
Consider a borrower taking a $10 million loan with a 10-year fixed term, amortized over 25 years at an interest rate of 7.00%. The monthly payment is $70,677.92, with a remaining balance of $7,863,339.64 due at maturity.
If the borrower pays one point ($100,000) to reduce the rate to 6.75%, the monthly payment falls to $69,091.15, and the balance at maturity declines to $7,807,708.64. That creates:
- Cash flow savings: about $1,587 per month, or $19,041 per year.
- Breakeven on cash flow: 5.25 years ($100,000 ÷ $19,041).
- Balloon benefit at year 10: $55,631 reduction in the maturity balance.
Over the full 10-year term, the total benefit is roughly $246,000, well above the $100,000 upfront cost. In other words, investing $100,000 today saves $246,000 over 10 years. That’s a 146% return on investment, or approximately 9.4% annualized, assuming the borrower holds the full term.
If the property is refinanced or sold within two years, savings would only be about $38,000, falling short of breakeven.
Key Benefits
- Immediate cash flow improvement: Lower monthly debt service can improve cash flow from the outset, creating more cushion for operations, capital improvements, or distributions.
- Stronger debt service coverage: A reduced rate can push a borderline DSCR above lender thresholds, which may help a loan qualify in the first place or unlock better loan-to-value terms.
- Long-term interest rate protection: Locking in a lower fixed rate provides predictability in loan payments and hedges against future rate increases, particularly valuable in rising rate environments.
- Reduced balloon risk: Lower interest rates mean more principal paydown over the loan term, reducing the refinancing amount at maturity when future rates are uncertain.
Important Drawbacks
- Significant upfront capital requirement: A buydown requires hundreds of thousands of dollars at closing, reducing available liquidity for other uses right when you’re closing the deal.
- Breakeven risk: If the property is sold or refinanced before breakeven, typically 5+ years, the borrower loses part or all of the upfront investment with no way to recover it.
- Opportunity cost of capital: Money used for a buydown can’t be deployed for reserves, tenant improvements, leasing commissions, or other investments that might generate higher returns or provide more operational flexibility.
Beyond the Math: Other Considerations
- Tax treatment: The buydown fee may be amortizable over the loan term rather than immediately deductible.
- Prepayment penalties: If the borrower refinances early, yield maintenance or defeasance costs can erase the buydown savings.
- Lender flexibility: Some lenders offer rate buydowns as a negotiating tool when they’re eager to close a deal.
Best-Fit Property Types
Rate buydowns are most common in stabilized, cash-flowing assets where the borrower intends to hold long-term. Multifamily properties with agency financing, office buildings with long leases in place, and industrial properties with credit tenants are typical candidates. They are less common in speculative development, transitional assets, or short-term bridge loans where refinancing or disposition is expected within a few years.
Conclusion
Rate buydowns are not a one-size-fits-all solution. They can reduce interest costs and strengthen loan metrics, but only when the hold period and capital strategy align with the upfront expense. For some borrowers, they are a smart way to improve long-term cash flow. For others, preserving capital for operations or improvements will deliver greater value. Careful analysis of both the math and the business plan is essential before deciding whether to buy down a rate.