January 10, 2000, Revised August 29, 2007, Revised
April 1, 2022

"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?"

There are two ways to answer this question. One way is to view the two uses of the available cash as investments, calculating the rate of return in each potential use. This is the approach used in the earlier version of this article. The second and current approach, is to compare total costs over periods that reflect borrowers’ expectations regarding how long they might remain in their house.

PART 1: RATE OF RETURN APPROACH

__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 upfront 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

PART 2: COST COMPARISON APPROACH

This approach is simpler than the rate of return approach
in requiring only one calculator. See
https://www.mtgprofessor.com/ext/partners/ShopYourLoan.aspx

The table below is drawn from that calculator. It shows
clearly that over 3 years, costs are reduced more by making
a larger down payment but over 12 years costs are reduced
more by paying points. The table covers a 30-year fixed rate
mortgage.

Paying Points Versus
Larger Down Payment: Impact of a Cash Infusion of $25,000
Used to Increase the Down Payment on a $500,000 House or
Reduce the Interest Rate by Paying Points

Use of Cash
Infusion |
Loan Amount |
Ratio of Loan to
Value |
Interest Rate |
Points |
Total Costs Over
12 Years |
Total Costs Over
3 Years |

None |
$475,000 |
95% |
4.625% |
$375 |
$207,170 |
$54,818 |

Larger Down
Payment |
$450,000 |
90% |
4.625% |
$356 |
$189,240 |
$50,568 |

Payment of
Points |
$475,000 |
95% |
3.25 |
$26,078 |
$171,090 |
$62,032 |

Note: Total costs include points, mortgage payments,
mortgage insurance (if any), less reduction in loan balance,
over 3-12 years. The home is a single-family primary
residence to be purchased by a borrower with a FICO score of
800. Prices are as of April 1, 2022.

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