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January 10, 2000, Revised August
29, 2007 "I have enough cash
to increase my down payment from 5% to 10%, or to pay up to 5 points, but
not both… Which is better?"
Paying
Points and Increasing the Down Payment Are Investments
You can reduce or eliminate private mortgage
insurance (PMI) if you increase the down payment, and you can reduce the interest rate
by paying points. Both can be viewed as investments on which you make an up front cash outlay and receives a stream of income in
the future. With a larger down payment, the income is the reduction in
monthly payment that results from the smaller loan and mortgage insurance
premium. With points, the income is the reduction in monthly payment that
results from the lower interest rate.
As with any investment,
you can estimate a rate of return. The better deal is the investment
that yields the higher return over the period you stay in the
home.
Factors
Affecting the Return on Investment
The return on investment in points
is extremely sensitive to how long you stay in the home. For example,
suppose you
are in the 28 percent tax bracket and pay 4.5 points to reduce the rate on
a 30-year fixed-rate mortgage from 8 percent to 7 percent. If you stay in
your house for 3 years, your after-tax return is a negative 17.8%. If you
stay for 15 years your return is positive 15.9%.
The return on an investment in a
larger down payment is much less sensitive to how long you remain in your
house. For example, to reduce the mortgage insurance premium on the same
mortgage from .78% to .52% of the loan amount ,
you increase your down payment from 5% of property
value to 10%. The after-tax return over 3
years is 11.3% and over 15 years it is 10.9%.
Finding
the Answer in an Individual Case
The moral is very clear. If your
time horizon is short, you should invest in a larger down payment, and if
it is long, you should invest in higher points.
How long is "long"? In
most cases the crossover point where the returns are the same occurs in 8
years or less. However, the cross over point is affected by a number of
factors including your tax bracket; PMI premiums; the rate reduction you
receive for a given increase in points; and appreciation of your house,
which affects how long you'll carry PMI.
You can analyze your own situation
with three calculators :
12a. Rate
of Return From Investing in a Larger Down Payment
11c. Rate
of Return From Investing in Points on Fixed-Rate Mortgages
11d. Rate
of Return From Investing in Points on Adjustable-Rate Mortgages
Copyright Jack Guttentag
2007
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