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March 7, 2005
The Down
Payment Decision: Borrower Can Put Nothing Down
In answering this
question, I place borrowers into three groups. One group has no money for a down
payment, so they have no down payment decision to make. Their problem is
qualifying for a loan without a down payment.
The
Down Payment Decision: Borrower Can Put Less than 20% Down
The second group consists of those who can make
a down payment of less than 20%. They must decide whether to put down the most
they can afford, or something less � 5%, say, when they can afford 10%? See
The Pros and Cons of
Making a Larger Down Payment.
Those in the second group must then decide
whether to take a larger first mortgage, say 90% of value, and pay for mortgage
insurance; or take an 80% first mortgage plus a second ("piggyback") mortgage at
a higher rate for the additional amount needed. See
Can Two Mortgages Cost Less than One?
The
Down Payment Decision: Borrower Can Put More Than 20% Down
The third group consists of those who can afford
to put more than 20% down, perhaps even 100%, and must decide how much it should
be? They are the subject of this article.
Assume Jacques has $100,000 of surplus cash,
over and above the 20% he will put down. He can use the $100,000 either to make
a larger down payment, or he can continue to hold it as an investment. His
objective is to have the most wealth at the end of the period during which he
expects to be in the house; or, if his wealth is the same at that point, he
wants to select the option that will allow him to spend more over the period.
There is one simple rule that, if followed, will
achieve this objective. Take the mortgage
if the investment return on the $100,000 is higher than the mortgage rate. If
the investment return is lower than the mortgage rate, use the $100,000 as an
additional down payment.
This is an application of the standard
investment rule, that the better investment is the one providing the higher
return. Increasing the down payment is an investment in the mortgage you avoid,
on which the yield is the
mortgage rate you don't pay. For example, if you put $100,000 down instead of
borrowing that amount at 6%, your return on the $100,000 is the 6%
you would have paid on the mortgage. If the alternative use of the
$100,000 is to keep it in the bank earning 3%, you do better using it to make a
larger down payment.
Here is a simple example that will
illustrate the principle. If Jacques earns 3% on his $100,000 of financial
assets, his investment income is $250 a month. If the 6% mortgage he is
considering is interest-only, it will cost him $500 a month. Net, he loses $250
a month.
If, instead, he uses the $100,000 to increase
his down payment, he has no investment income or mortgage interest to pay, so
his income from these sources is zero. He thus has $250 a month in disposable
income that he would not have had he taken the mortgage. He can live a richer
life by spending it, or he can invest it and end up with more wealth, or some
combination of the two.
An investment in mortgage avoidance makes good
sense for elderly home buyers whose money is invested very conservatively. Their
objective is more likely to be maintaining consumption rather than increasing
wealth. So long as the mortgage rate exceeds the yield on their investments,
consumption at a given level will deplete their wealth less rapidly if they
avoid a mortgage.
Home buyer with excess cash who can earn a
return above the mortgage rate may do better taking the mortgage. It may pay to
take a mortgage at 6% if you can invest at 10%. I say "may" rather than "will"
because any investments that promise yields above the mortgage rate carry risk,
whereas the return on mortgage avoidance has no risk.
Younger buyers with excess cash are in the best
position to assume the risks. If they take the mortgage and invest their cash in
a diversified portfolio of common stock, they have an excellent chance of
earning 9-10% over a long period. Because they are young, they can take a long
view and ride out short-term fluctuations in the stock market.
But they should have the stomach for it. If they
are going to have a gastric upset every time the value of their portfolio drops,
they should opt for the safe return on investment in mortgage avoidance.
Copyright Jack Guttentag 2005
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