Consumers looking to purchase a home within the near future
face many decisions, including how large a down payment to
make. The down payment is the sale price (confirmed by a
appraisal) less the loan amount. In most cases, home
purchasers must have financial assets at least as large as
the down payment they make.
Down Payment as an Investment:
Many consumers put down as little as possible despite having
the capacity to put down more because they view the down
payment as lost money. But that is a mistake. The down
payment is an investment that yields a return that is far
above anything else available to consumers, and the return
is 100% risk-free. Here is an example.
John is planning to purchase a house for
$200,000 financed with a mortgage of $190,000 priced at
4.25% and 1 point. His $10,000 down payment is 5% of the
price. He is retaining another $10,000 in a money market
fund that is currently yielding him less than 1%. If he uses
that $10,000 instead to increase the down payment to 10%, or
(even better) if he can save that amount before the deal is
executed, his rate of return on the $10,000 will be 7-8%,
depending on how long he has the mortgage. And there is no
risk.
Return Derived From Loan Elimination:
Where does the yield come from? Part of it comes from the
elimination of $10,000 of mortgage loan on which he would be
paying 4.25% and 1 point. He retains the interest and points
on the $10,000 he does not borrow. Assuming he has the loan
for 7 years, this component of the return is 4.43%.
Some readers may have difficulty with this
concept, but it is quite straightforward. If you invest
$10,000 in a security, your return is the interest paid to
you by the security issuer. If you invest $10,000 in a down
payment, the return to you includes the interest and points
you do not have to pay the mortgage lender on the
$10,000 you don’t borrow.
Return Derived From Reducing the Cost
of the Remaining Loan: But
the rate of return on down payment has a kicker that has no
counterpart in the securities market. The home purchaser who
increases the down payment not only eliminates the charge on
the loan that isn’t made, but reduces the charge on the loan
that is made. In John’s case, in addition to the saving on
interest and points on the $10,000 he does not borrow, he
reduces the mortgage insurance premium on the $180,000 he
will borrow.
On a $190,000 loan with 5% down, assuming
the borrower has excellent credit, the monthly mortgage
insurance premium is about $85, whereas on a $180,000 loan
with 10% down, the premium is about $58. This reduction in
premium increases the rate of return on the $10,000
investment in down payment to about 7.88%.
Readers interested in making similar
calculations on their own transactions can do them with
calculator 12a on my web site.
Why Loan Costs Decline With Larger Down
Payments: The larger the
down payment, the lower the risk of loss to the lender. In
the event the borrower defaults, the likelihood that the
unpaid debt will exceed the property value is smaller when
the down payment is larger. In addition, borrowers who have
been able to save the funds for a larger down payment are
viewed as less likely to default because of their
demonstrated budgetary discipline. The result is that the
mortgage price declines as the down payment
rises.
In our system, a major part of the risk
associated with low down payments is shifted from the lender
to a mortgage insurer, but this changes nothing of
substance. Mortgage insurance premiums decline as the down
payment rises, and hit zero at 20% down.
Saving For a Down Payment:
Consumers who are actively planning to purchase a house will
base their down payment decision on the financial assets
they now have. Consumers looking ahead to a time when they
hope to be better positioned to purchase a house, must
develop a savings plan. In doing this, they should assume
that the return they earn on the new savings is 1.5 times
the prevailing home mortgage interest rate. This is a
conservative estimate of the rate of return on the savings
when it is used as a down payment to buy a house.
If home purchase is in your plans but you have never been
able to save, it is time you learned how. The secret is to
give saving high priority in your budget. Decide beforehand
what part of your income you can afford to save, and create
a special account for that purpose. Then immediately after
you are paid, write a check for deposit in that account. If
you view saving as a residual – what remains of your income
unspent at the end of the month –you are giving saving the
lowest possible priority, which is a virtual guarantee of
failure.
