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 an 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 percent 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 percent and 1 point. His $10,000 down payment is 5 percent of the price. He is retaining another $10,000 in a money market fund that is currently yielding him less than 1 percent. If he uses that $10,000 instead to increase the down payment to 10 percent, 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 percent, 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 percent and 1 point. He retains the interest and points on the $10,000 he does not borrow. Assuming he has the loan for seven years, this component of the return is 4.43 percent.
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 percent down, assuming the borrower has excellent credit, the monthly mortgage insurance premium is about $85, whereas on a $180,000 loan with 10 percent 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 percent.
Readers interested in making similar calculations on their own transactions can do them with calculator 12a on my website ( www.mtgprofessor.com ).
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 percent 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 a 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.
ABOUT THE WRITER
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
(c)2014 Jack Guttentag
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