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The Pros and Cons of Making a Larger Down Payment

The Pros and Cons of Making a Larger Down Payment

November 22, 1999

"I have my money at work earning a 12-14% return year-in and year-out. My thinking, therefore, is that I should make the smallest down payment possible because the return on a larger down payment will be the 7.5% mortgage interest rate I expect to pay on my fixed-rate mortgageļæ½Is there a flaw in my thinking?"

Your approach is right. A larger down payment is an investment that yields a return that consists in part of the interest rate on the money you aren't borrowing. If you put an additional $10,000 down, for example, you are borrowing $10,000 less and you save the interest that you would have paid on it. But there may be other savings as well that make the return higher than the interest rate on the loan.

First, most borrowers pay points or other loan fees expressed as a percent of the loan amount. If you borrow $10,000 less, you save not only the interest but the upfront fees on the $10,000. If you are paying 3 points on your fixed-rate mortgage, for example, and your time horizon is 7 years, the rate of return on the increase in down payment is 8.08% rather than 7.50%. Fees of fixed dollar amount don't affect the return because they aren't reduced when the loan amount is reduced.

A second possibility is that the larger down payment reduces or eliminates mortgage insurance, which must be purchased when the down payment is less than 20% of property value. In such event, the return on the larger down payment includes not only the savings in interest and points but also the mortgage insurance that is eliminated by the larger down payment.

If a $10,000 increase in down payment increases the ratio of down payment to property value from 10% to 20%, for example, you eliminate a mortgage insurance premium of about .52% on a fixed-rate mortgage. This would bring the return on the increase in down payment over 7 years to 13.00%, which is what you are earning on your other assets. The difference is that the return on investment in a down payment has no risk to you whereas your other investments are risky. If the returns are about the same, the down payment investment is preferable.

Still a third possibility is that the larger down payment reduces the interest rate by bringing the loan amount below $252,700. Because the Federal secondary market agencies, Fannie Mae and Freddie Mac, cannot purchase mortgages larger than $252,700, the market breaks at that point. Interest rates on loans larger than $252,700 are 1/4 to 3/8% higher.

If you are purchasing a house for $285,000, for example, an increase in down payment from 10% to 20% would be $28,500, and the loan amount would drop from $256,500 to $228,000. Assuming the rate falls from 7.5% to 7.25%, the return on the down payment would rise to 14.95%. The rate reduction of .25% results in an increase in the return on the additional down payment of almost 2% because the rate reduction applies to the entire loan while the benefit is credited to the increase in the down payment.

The numbers I quoted above all come from a new calculator on my web site that calculates the rate of return earned on amounts invested in a larger down payment. The calculator is easy to use, even if you don't understand everything you just read. You just tell the calculator the down payment increase you want to test, along with the other obvious pieces of information that it needs, such as the term, and it does the rest.  To use the calculator, click on Rate of Return From Investing in a Larger Down Payment .

It took me about a minute to do these three passes at your problem, but I'm familiar with the calculator so it might take you 2 minutes. If you give the calculator your tax bracket, it will also calculate the return after taxes. But if you want to make rate of return comparisons with other assets, you must remember to convert the returns on the other assets to an after-tax basis as well. You do that by multiplying the before-tax return by 1 minus your tax rate. If you are in the 28% tax bracket, for example, a before-tax return of 10% becomes 7.20% after tax.

Copyright Jack Guttentag 2002


Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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