Invest Xtra Cash in Securities or Larger Down Payment?
August 19, 2002, Reviewed September 7, 2007
This article explains how to compare a loan carrying a down payment with a loan without a down payment where the funds that would have been used for down payment are invested in securities.
"We will have $100,000 from the equity in our current house when we sell it, and plan to buy a new house for $200,000. We are considering two financing options. Option 1 is to take a no down payment 30-year loan at 7.75%, investing the $100,000 in securities. Option 2 is to use the $100,000 as down payment on a 15-year loan at 6.75%. Which is better?"
You should think of this as a selection between two investments. One investment is securities. The other is a "less mortgage" investment. By making a larger down payment you are borrowing less, and the amount you are borrowing is being paid off over a shorter period.
When you compare investments, you should select the one that provides the highest yield, after adjusting for differences in their risk and liquidity. (Liquidity is how easy it is to convert the investment back into cash). Whoever sells you a security will be able to tell you the yield, and usually they can provide information on risk and liquidity as well. Many investors do their own research on securities, and sources of information are readily available.
Measuring the yield on the "less mortgage" investment is more of a challenge. Many people have difficulty with the concept. They are accustomed to thinking that an investment involves paying money today and receiving a return flow of money in the future, which is what happens when you purchase a security.
But a decision not to borrow is the same thing. The money you give up today is the money you would have had if you had borrowed. And the return flow in the future consists of the larger payments you avoid by not borrowing. It also includes the smaller debt you would have if you terminate the loan anytime prior to term.
In your case, the amount invested is the $100,000 you don’t borrow, which is the down payment. The return on that investment has two parts. First, the monthly payment is $548 lower for 15 years. The lower payment is due to the smaller loan amount and the lower interest rate, which are only partly offset by the shorter term. Second, at the end of 15 years, you save $152,219, which is the amount you would have owed at that point had you taken the 30-year loan.
The yield on the "less mortgage" investment over 15 years is 8.33%, and it is risk free. Since there are no risk-free investments around that generate this kind of return, I would vote for that option.
I calculated the yield with a spreadsheet program that handles all differences between the larger and smaller mortgage. This includes points and other upfront charges, which must be taken account of in an accurate yield measurement. It also shows the yield over every possible time horizon.
For example, if both mortgages have an upfront charge of 2 points (2% of the loan), the yield would increase from 8.33% to 8.54% over 15 years, and from 8.61% to 9.08% over 5 years.
The "less mortgage" investment may have less liquidity than marketable securities, since you can’t sell a piece of your house as you can sell some of your securities. With the significant equity in your house, however, getting a home equity loan at favorable terms is very easy. Differences in liquidity would not change my selection.
Readers who want to use the spreadsheet to analyze their own unique situation can get it by clicking on Invest in Less Mortgage.
This article explains how to compare a loan carrying a down payment with a loan without a down payment where the funds that would have been used for down payment are invested in securities.
"We will have $100,000 from the equity in our current house when we sell it, and plan to buy a new house for $200,000. We are considering two financing options. Option 1 is to take a no down payment 30-year loan at 7.75%, investing the $100,000 in securities. Option 2 is to use the $100,000 as down payment on a 15-year loan at 6.75%. Which is better?"
You should think of this as a selection between two investments. One investment is securities. The other is a "less mortgage" investment. By making a larger down payment you are borrowing less, and the amount you are borrowing is being paid off over a shorter period.
When you compare investments, you should select the one that provides the highest yield, after adjusting for differences in their risk and liquidity. (Liquidity is how easy it is to convert the investment back into cash). Whoever sells you a security will be able to tell you the yield, and usually they can provide information on risk and liquidity as well. Many investors do their own research on securities, and sources of information are readily available.
Measuring the yield on the "less mortgage" investment is more of a challenge. Many people have difficulty with the concept. They are accustomed to thinking that an investment involves paying money today and receiving a return flow of money in the future, which is what happens when you purchase a security.
But a decision not to borrow is the same thing. The money you give up today is the money you would have had if you had borrowed. And the return flow in the future consists of the larger payments you avoid by not borrowing. It also includes the smaller debt you would have if you terminate the loan anytime prior to term.
In your case, the amount invested is the $100,000 you don’t borrow, which is the down payment. The return on that investment has two parts. First, the monthly payment is $548 lower for 15 years. The lower payment is due to the smaller loan amount and the lower interest rate, which are only partly offset by the shorter term. Second, at the end of 15 years, you save $152,219, which is the amount you would have owed at that point had you taken the 30-year loan.
The yield on the "less mortgage" investment over 15 years is 8.33%, and it is risk free. Since there are no risk-free investments around that generate this kind of return, I would vote for that option.
I calculated the yield with a spreadsheet program that handles all differences between the larger and smaller mortgage. This includes points and other upfront charges, which must be taken account of in an accurate yield measurement. It also shows the yield over every possible time horizon.
For example, if both mortgages have an upfront charge of 2 points (2% of the loan), the yield would increase from 8.33% to 8.54% over 15 years, and from 8.61% to 9.08% over 5 years.
The "less mortgage" investment may have less liquidity than marketable securities, since you can’t sell a piece of your house as you can sell some of your securities. With the significant equity in your house, however, getting a home equity loan at favorable terms is very easy. Differences in liquidity would not change my selection.
Readers who want to use the spreadsheet to analyze their own unique situation can get it by clicking on Invest in Less Mortgage.