Dave,
Essentially the seller pre-pays the interest on the borrower's behalf for the first 2 years using the buydown money. Paying 2%/month the first year and 1%/month in year 2. In year 3 the buyer is paying the ful principal and interest payment. Like I show above, this gives a much better "bang for the buck" on a monthly cash flow basis for a potential buyer than simply dropping the price. Most folks don't buy a home based on the purchase price--they buy based on their ability to afford the monthly payment. This strategy allows a buyer to ease into their full payment like an old man easing into a hot bath. :)

Great question about buyers using this strategy to buy a larger house and take on a payment they cannot afford down the road. The loan actually has an underwriting condition that the buyer must qualify at the full payment--not the payment in the first year. Therefore, the buyer cannot use this strategy to "game" the system. The intention here is to keep the payment lower at the beginning of the ownership period that in general tends to be the most expensive--new furniture, new window treatments etc---that stuff ain't cheap! This strategy can make that period more comfortable financially.