Make a Larger Down Payment or Pay Points?

Mortgage borrowers with enough money to make a down payment larger
than the minimum must decide whether to increase the down payment or pay
points. This is an investment decision that should be based on which
option yields the higher rate of return.

*Borrowers With Long Time Horizons, Who Don’t Have Enough Money
to Make a Meaningful Increase in Down Payment (See below), Should
Consider Paying Points: * In today’s market, the 4.50%
rate on a 30-year fixed-rate loan to a prime borrower could be reduced
to 4% by paying 2.6 points -- that is 2.6% of the loan amount. Over the
next 12 years, that would earn a return of 11.5%. If the mortgage is
terminated after 5 years, however, the interest saved would not cover
the cost of the points, resulting in a negative rate of return.

The
rate of return from an investment in points on a fixed-rate
mortgage can be derived using calculator 11c on my web site.

*Investing a Small Amount in a Larger Down Payment Yields a
Modest Return:* A borrower putting 5% down who elects to
increase the down payment to 6% or 7% earns a return equal to the
mortgage rate, or just a little higher, regardless of how long the
mortgage is in force. The return is a little higher than the mortgage
rate because of upfront fees scaled to the loan amount.

*To Generate a Higher Yield, the Investment in a Larger Down
Payment Must Be Large Enough toFlip the Loan into a Lower Mortgage
Insurance Premium or Interest Rate Category.* Mortgage
insurance premium categories, expressed in down payments, are generally
3-4.99%, 5-9.99%, 10-14.99%, and 15-19.99%. Where lenders pay for the
mortgage insurance and price it in the rate, they use the same
categories.

If the borrower taking a 4.5% mortgage at zero points with 5% down
raises the down payment to 10%, the loan shifts into the 10-14.99%
mortgage insurance premium* *category*. *Since the premium is
lower, the return on investment over 12 years rises to 7%.

The
rate of return from an investment in down payment on a
fixed-rate mortgage can be derived using calculator 12a on my web site

*Increasing the Down Payment on a Loan Slightly Larger Than the
Conforming Loan Limit Increases the Rate of Return. *The
conforming loan limit is the maximum size mortgage that can be purchased
by Fannie Mae and Freddie Mac. A loan for $453,101 will carry a rate
about ¼% higher than a loan of $453,100, which is the current maximum.
Hence, a borrower contemplating a down payment that would result in a
loan amount slightly above the conforming loan limit should consider
raising the down payment by enough to get under the limit.

*Borrowers Forced Into a Non-Qualified Mortgage Earn the Highest
Return on Investment In a Larger Down Payment: *Last
week I wrote about mortgages which for one reason or another did not
meet the requirements established by Dodd/Frank for the standard
mortgage designation. One consequence of this designation is that we now
have lenders specializing in non-qualified mortgages who operate in a
manner very similar to sub-prime lenders before the financial crisis.
One striking point of similarity is that mortgage insurance is not
required but variability in interest rate associated with differences in
down payment is very large. A result is that the rate of return to the
borrower on an investment in a larger down payment is very high.

As an example, one lender of non-qualified mortgages whose price
sheets I managed to access quoted 6.625% on a high credit score
transaction with 10% down, and 5.375% with 20% down. The rate of return
to the borrower on the down payment increase would be 12.2% calculated
over 12 years. With a low credit score borrower, the rates were 8.375%
and 7.375%, resulting in a return on investment of 15.9%.

The bottom line is that mortgage borrowers who fall into the
highest price categories, whether because of their credit history, weak
documentation or whatever, can earn the highest rate of return on
investments in larger down payments.

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