Invest In Mortgage Points or Larger Down Payment?

January 10, 2000 "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?" Most borrowers are aware that they can reduce or eliminate private mortgage insurance (PMI) if they increase their down payment. Few are aware that in some circumstances paying points to reduce their interest rate is a better deal. You can view both an increased down payment and increased points as an investment. In both cases, the borrower makes an up front 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.  In both cases you can calculate the rate of return on the investment. The better deal is the investment that yields the higher return over the period the borrower stays in the home. The return on investment in points is extremely sensitive to how long you stay in the home. For example, 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 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%. 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: Rate of Return From Investing in a Larger Down Payment  Rate of Return From Investing in Points on Fixed-Rate Mortgages Rate of Return From Investing in Points on Adjustable-Rate Mortgages 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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