The Pros and Cons of Making a Larger Down Payment
November 22, 1999, Revised September 4, 2007
The benefits of a larger down payment consist of the mortgage interest saved by borrowing less, fees expressed as a percent of the loan that are saved by borrowing less, lower mortgage insurance premium (or smaller piggyback mortgage) if the initial down payment was less than 20%, and possibly a lower interest rate if the loan amount falls below the conforming loan ceiling.
"I have my money at work earning a 12-14% return year-in and year-out. My thinking, therefore, is that I should make the smallest down payment possible because the return on a larger down payment will be the 7.5% mortgage interest rate I expect to pay on my fixed-rate mortgage…Is there a flaw in my thinking?"
Interest Savings: Your approach is right. A larger down payment is an investment that yields a return that consists in part of the interest rate on the money you aren't borrowing. If you put an additional $10,000 down, for example, you are borrowing $10,000 less and you save the interest that you would have paid on it. But there may be other savings as well that make the return higher than the interest rate on the loan.
Points: Many borrowers pay points or other loan fees expressed as a percent of the loan amount. If you borrow $10,000 less, you save not only the interest but the upfront fees on the $10,000. If you are paying 3 points on your fixed-rate mortgage, for example, and your time horizon is 7 years, the rate of return on the increase in down payment is 8.08% rather than 7.50%. Fees of fixed dollar amount don't affect the return because they aren't reduced when the loan amount is reduced.
Mortgage Insurance/Piggybacks: A larger down payment reduces or eliminates mortgage insurance if the previous down payment is less than 20% of property value. In such event, the return on the larger down payment includes not only the savings in interest and points but also the mortgage insurance that is eliminated by the larger down payment.
If a $10,000 increase in down payment increases the ratio of down payment to property value from 10% to 20%, for example, you eliminate a mortgage insurance premium of about .52% on a fixed-rate mortgage. This would bring the return on the increase in down payment over 7 years to 13.00%, which is what you are earning on your other assets. The difference is that the return on investment in a down payment has no risk to you whereas your other investments are risky. If the returns are about the same, the down payment investment is preferable.
Note that in recent years, piggyback second mortgages have replaced mortgage insurance in many transactions. Where this is the case, the saving becomes the reduced size of the second mortgage, which carries a rate above that on the first mortgage.
Dropping the Loan Below the Conforming Loan Limit: Still a third possibility is that the larger down payment reduces the interest rate by bringing the loan amount below $417,000, the limit in 2007. Because the Federal secondary market agencies, Fannie Mae and Freddie Mac, cannot purchase mortgages larger than $417,000, the market breaks at that point. Interest rates on loans larger than that were 1/4% to 3/8% higher when this article was first written, though in August 2007 it was more than twice as large because of the market disarray at that time. Using just a 1/4% spread, the return on the down payment would rise to 14.95%.
The numbers I quoted above all come from calculator 12a that calculates the rate of return earned on amounts invested in a larger down payment. The calculator is easy to use, even if you don't understand everything you just read. You just tell the calculator the down payment increase you want to test, along with the other obvious pieces of information that it needs, such as the term, and it does the rest. To use the calculator, click on Rate of Return From Investing in a Larger Down Payment.
It took me about a minute to do these three passes at your problem, but I'm familiar with the calculator so it might take you 2 minutes. If you give the calculator your tax bracket, it will also calculate the return after taxes. But if you want to make rate of return comparisons with other assets, you must remember to convert the returns on the other assets to an after-tax basis as well. You do that by multiplying the before-tax return by 1 minus your tax rate. If you are in the 28% tax bracket, for example, a before-tax return of 10% becomes 7.20% after tax.
Caution: In comparing the yield on a larger down payment with the yield on investment in financial assets, you are implicitly assuming that the reduction in monthly mortgage payment resulting from the rise in down payment, will be invested in the alternative asset. I discuss this in Pros and Cons of Paying Cash For a House.
Another Approach
An alternative way to view the down payment decision is in terms of what is possible for an individual borrower. This approach is used in How Much Should I Put Down?
The benefits of a larger down payment consist of the mortgage interest saved by borrowing less, fees expressed as a percent of the loan that are saved by borrowing less, lower mortgage insurance premium (or smaller piggyback mortgage) if the initial down payment was less than 20%, and possibly a lower interest rate if the loan amount falls below the conforming loan ceiling.
Benefits of a Larger Down Payment
"I have my money at work earning a 12-14% return year-in and year-out. My thinking, therefore, is that I should make the smallest down payment possible because the return on a larger down payment will be the 7.5% mortgage interest rate I expect to pay on my fixed-rate mortgage…Is there a flaw in my thinking?"
Interest Savings: Your approach is right. A larger down payment is an investment that yields a return that consists in part of the interest rate on the money you aren't borrowing. If you put an additional $10,000 down, for example, you are borrowing $10,000 less and you save the interest that you would have paid on it. But there may be other savings as well that make the return higher than the interest rate on the loan.
Points: Many borrowers pay points or other loan fees expressed as a percent of the loan amount. If you borrow $10,000 less, you save not only the interest but the upfront fees on the $10,000. If you are paying 3 points on your fixed-rate mortgage, for example, and your time horizon is 7 years, the rate of return on the increase in down payment is 8.08% rather than 7.50%. Fees of fixed dollar amount don't affect the return because they aren't reduced when the loan amount is reduced.
Mortgage Insurance/Piggybacks: A larger down payment reduces or eliminates mortgage insurance if the previous down payment is less than 20% of property value. In such event, the return on the larger down payment includes not only the savings in interest and points but also the mortgage insurance that is eliminated by the larger down payment.
If a $10,000 increase in down payment increases the ratio of down payment to property value from 10% to 20%, for example, you eliminate a mortgage insurance premium of about .52% on a fixed-rate mortgage. This would bring the return on the increase in down payment over 7 years to 13.00%, which is what you are earning on your other assets. The difference is that the return on investment in a down payment has no risk to you whereas your other investments are risky. If the returns are about the same, the down payment investment is preferable.
Note that in recent years, piggyback second mortgages have replaced mortgage insurance in many transactions. Where this is the case, the saving becomes the reduced size of the second mortgage, which carries a rate above that on the first mortgage.
Dropping the Loan Below the Conforming Loan Limit: Still a third possibility is that the larger down payment reduces the interest rate by bringing the loan amount below $417,000, the limit in 2007. Because the Federal secondary market agencies, Fannie Mae and Freddie Mac, cannot purchase mortgages larger than $417,000, the market breaks at that point. Interest rates on loans larger than that were 1/4% to 3/8% higher when this article was first written, though in August 2007 it was more than twice as large because of the market disarray at that time. Using just a 1/4% spread, the return on the down payment would rise to 14.95%.
Using Calculator 12a
The numbers I quoted above all come from calculator 12a that calculates the rate of return earned on amounts invested in a larger down payment. The calculator is easy to use, even if you don't understand everything you just read. You just tell the calculator the down payment increase you want to test, along with the other obvious pieces of information that it needs, such as the term, and it does the rest. To use the calculator, click on Rate of Return From Investing in a Larger Down Payment.
It took me about a minute to do these three passes at your problem, but I'm familiar with the calculator so it might take you 2 minutes. If you give the calculator your tax bracket, it will also calculate the return after taxes. But if you want to make rate of return comparisons with other assets, you must remember to convert the returns on the other assets to an after-tax basis as well. You do that by multiplying the before-tax return by 1 minus your tax rate. If you are in the 28% tax bracket, for example, a before-tax return of 10% becomes 7.20% after tax.
Caution: In comparing the yield on a larger down payment with the yield on investment in financial assets, you are implicitly assuming that the reduction in monthly mortgage payment resulting from the rise in down payment, will be invested in the alternative asset. I discuss this in Pros and Cons of Paying Cash For a House.
Another Approach
An alternative way to view the down payment decision is in terms of what is possible for an individual borrower. This approach is used in How Much Should I Put Down?