The Dangers of a Big Down Payment
In today’s real estate world you have a multitude of options headed your way.
First of course you need to decide where you want to live and then the type of home you’d like to have.
You also set down a price range with your real estate agent. There’s financing you’ll need to consider and you’re presented yet again with a whole host of decisions to make. Do you want an adjustable rate mortgage or is a fixed better for you? Perhaps a 7/1 or 10/1 hybrid?
Should you pay points to lower your rate? And what about closing costs? These are all choices you’ll have to make alongside your loan officer who can present current financing options and monthly payments.
But what about your down payment? How much should you put down when buying your next home? A lot? As little as possible?
Financial Benefits: Equity Decisions
More than likely when you’re considering buying a $1 million dollar property it’s not your first home. That said you’ve already experienced first-hand how property values can appreciate as well as go the other direction and you also know the loan approval process fairly well. The down payment decision is yours but you should certainly review your options with your financial planner or certified public accountant about any future purchase you will make because you will be pulling liquid and semi-liquid funds into real estate.
You can certainly do your own research and I’m sure you’ll do lots of it but you will soon find that not everyone’s financial situation is really exactly the same. Some may be similar but once you get past how much money someone makes at their company then a whole new realm of possibilities appear as it relates to what people do with their capital once it’s acquired. Do they distribute their savings among various investment types? A couple can have an IRA as well as an active 401(k) account but no other assets such as gold or silver. Another couple can own an IRA, a 401(k), precious metals as well as a good dose of equities. Where to put money is a very personal choice and once a decision is made to acquire an asset, any asset, it affects the entire financial picture. When you decide to put equity in one place you’ve also just decided where not to place it.
When you access your liquid funds to use as a down payment you’ve just made the choice not to invest in bonds, equities or precious metals in the very same manner. It does matter how much you put down but it’s very easy to find “advice” that says to put as much money down as possible. And for many that can make sense but it’s not necessarily universal advice.
You certainly need to put the minimum amount needed to finance a property but should you put down more?
How Much More?
Should you put down more than the minimum? There can be a few reasons and one of them is to make sure you qualify the new mortgage. If your loan officer says you’re qualified to borrow $900,000 it really doesn’t matter what the sales price can be. You put down enough to get qualified. An easy example of this concept is buying a $10 million dollar home overlooking the Pacific and put $9.1 million as a down payment. You qualified for the $10 million dollar home but in reality you qualified for a $900,000 loan. Some advise putting as much money down as you can possibly stand.
Because the amount of the down payment is also instant equity in the home. You’re not spending anything you’re just transferring some assets from cash to real estate. But if more down payment is better than a minimum down payment then is cash preferable over a mortgage?
That’s an entirely different concept and depends upon so many other factors such as your age, if this is your first or last home or how much you lose by not investing those funds in other vehicles instead of tying it up in real estate.
Real estate is not the most liquid of assets. Yes, you can always tap into the equity when you refinance the loan using a cash out refinance. Or, you can place a home equity line of credit on the property and access the funds in that manner although a home equity line of credit will carry a higher interest rate compared to a first mortgage. And obviously you can get at the equity in your real estate when you sell the home, less the costs encountered to close the sale such as real estate agent commissions, title insurance and the entire range of closing costs needed to dispose of the asset. Any time you want to know how much your home is currently worth and how much you would net from a sale simply contact your real estate agent. He or she will be more than happy to provide you with the numbers. That’s a potential sale and with a jumbo sale that’s also a lot of commissions to be spread around.
All these factors affect how much you should put down but there are also very powerful arguments made to put as little down as possible, especially in today’s interest rate environment.
Financial Benefits of a Low Down Payment…
A low down payment decision can come from need or desire. For those who have the option of putting as much money down as needed or paying all cash for a property are in a better situation perhaps than someone who really doesn’t have the option of a large down payment because their current financial situation dictates the amount.
There are companies that have recently restructured their employee’s bonus structures due to the current stock market flux and consumers would rather hold onto as much cash as they can instead of locking it up in real estate. Or, they don’t have as much cash saved or other assets to liquidate that make a 10% down jumbo mortgage loan more than just an option but a requirement.
It is also an advantage to leverage “other people’s money” when rates are so low. By now most consumers are aware that rates are very low. You would be hard pressed to find any home owner that is not aware that rates are currently at or near historic lows and even if the Fed did raise the Federal Funds rate last December it was the first such increase in nearly a decade and analysts are already thinking the Fed will sit on the sidelines with regard to any more rate increases in 2016, something the Fed essentially admitted recently and foretold earlier this year. The Fed began to turn bullish for the first time in a long, long time but the continued soft economy is keeping them on the dovish side.
So what do you do when rates are low? You take full advantage of them. If you can lock in a 10/1 hybrid rate of say 4.00% and as your income increases over the years your house payment remains the same for the next decade and your payment as a percentage of your income falls. Rates will go up, it’s just a matter of time and by locking in any rate at these levels will bring rewards in the future. Let’s also not forget the interest on any mortgage is tax deductible for most borrowers so the real cost of financing is actually lower as the mortgage interest deduction lowers taxable income.
Here is a major consideration regarding how much or how little to put down. It’s much, much easier to pay extra on your outstanding mortgage balance at any time compared to putting a larger down payment that perhaps someone is struggling with finding all the needed funds in order to put down that initial equity.
Let’s say you decide you want to put down 30% or even the loan program you’re qualified for requires a 30% down payment. If you don’t have it or you otherwise have to cash in some assets you’d really rather not, say an IRA or 401(k) account you’ll simply have to wait until you have that 30% available. Once you do have the 30% plus funds needed for closing costs and cash reserves, you would have a 70% loan-to-value loan. If in the future you wanted to access that equity, you would then apply for a home equity line of credit or a second lien, as long as the first lienholder doesn’t have any objections placing a subordinate lien.
On the other hand, let’s say you put down 10% and you decide on our 10% down jumbo loan program, you can buy the home now with 10% and if your goal is to get your loan to at least 70% of the current value, you can always pay the outstanding mortgage balance down at your convenience, whenever you want because the program has zero prepayment penalty provisions.
There are jumbo lenders who do offer adjustable rate mortgages as does most any mortgage company but the many of those programs require anywhere from 15% – 30% down and limit any secondary financing to 80% of the combined loan to value. This means a 20% down payment plus a 10% second mortgage.
Financial Benefits of 10% Down and No Private Mortgage Insurance
Let’s take a quick look at our 10% down program, keeping in mind the parameters of jumbo loan programs offered by other lenders. You may at first be thinking that, with any conventional mortgage loan, private mortgage insurance will be required if the first mortgage loan is more than 80% of the current value or sales price of the subject property. And with most mortgage programs that would be correct.
Private mortgage insurance, or PMI, is a separate insurance policy paid by the buyers with the beneficiary listed as the mortgage company issuing the loan. Let’s say that a property is listed for $1.2 million and the buyers want to put down 10% and borrow $1,080,000. A PMI policy is taken out and should the loan ever go into default the lender will be compensated the different between the standard 20% down and 10% down, or in this example, $120,000 at the outset.
Yet we have 10% down payment options for jumbo loans that do not require private mortgage insurance. For example, we ask only for a 10% down payment then combine a first and a second mortgage, ultimately financing 90% of the transaction and no private mortgage insurance premium.
Let’s look at an example of how this program can be used buying a $1 million dollar home with 10% down. The first mortgage would be at 75% of the value or $750,000 and a second, subordinate lien of $150,000. The minimum credit score for this special program is 730 and requires six months of cash reserves. Cash reserves are defined as the number of months’ worth or PITI, or principal, interest, taxes and insurance. For this program, the maximum property value is $1.6 million. This is indeed a very unique program we offer.
We also have a mortgage program for jumbo transactions with less than 20% down and require only a 15% down payment and a slightly higher credit score of 740. Cash reserve requirements are 18 months for this program and like the previous loan program it uses a first and second mortgage to complete the transaction. As with most of our other loan products, both fixed rate and the full range of hybrid options are available.
And you can still pay more against your outstanding balance any time you want. This is an especially popular provision for those who get paid bonuses or commissions at various times of the year.
Financial Benefits in Investments and Compound Interest
Okay, now let’s take a look at the advantages of holding onto your cash and investing in other vehicles and not use those funds as part of your initial equity. It’s important to note here this is not investment advice and any investments you make should be discussed with your financial planner or licensed portfolio manager. That said, let’s look at a sales price of $1.2 million and 10% down with you keeping $120,000 instead of turning it into a down payment.
Here’s a quote for you from someone you’re familiar with. “Compound interest is the eighth wonder of the world. He who understands it, earns it…he doesn’t…pays it.” Do you recognize who said that? None other than Albert Einstein. Really. So, then, what is compound interest?
Compound interest is interest earned on the original principal which is then added to the balance. Interest is then earned on top of interest. Simple interest is interest that is paid to the owner of the note and the balance of the asset never grows. For example, on a $10,000 note and a 5.0% simple interest dividend, each year interest accrues at $10,000 X 5.0% = $500. The $500 isn’t added back to the balance but paid out to the owner of the note. With a compound interest rate asset, the $500 is added back to the balance and the next period the 5.0% is calculated on $10,500 = $525 and so on.
In 10 years using compound interest at 5.0% the future value is $16,288. Now, instead of calculating the future value of $10,000 at 5.0% let’s look at the $120,000 you saved by not using it as part of your down payment. After 10 years, the $120,000 will grow to $195,467. That’s what Albert Einstein was talking about.
Any appreciable asset can be acquired using this $120,000 you saved in lieu of using it as a down payment. And as with any such investment, the earlier someone begins to save the greater the rewards that compound interest provides. The strategy of putting as little down as possible works best with those who are in the middle of or otherwise just starting out in their earning years. On the other hand, those on fixed incomes and those who are no longer working and enjoying the retirement years this may not be the best strategy as having as little debt as possible during retirement is typically the better option.
Financial Benefits of Leveraging…
Leveraging simply means reaping larger rewards with less input. This is the benefit of making a small down payment as you, the homeowner and borrower control more cash and therefore another asset. When the value of homes begins to appreciate, the asset grows in value with the minimum cash required. If after 10 years a $1 million dollar home is worth approximately $1.3 million with a $100,000 down payment, resulting in a $300,000 gain in wealth using a 3.0% annual property value increase. At a 5.0% annual property value increase after 10 years the homeowner gains another $628,000 in equity again using only a $100,000 down payment to secure the property.
Property values will rise and fall and we all know especially here in San Diego County that values can certainly take a fall but in just a few years property values have recovered from perhaps the worst recession since the 1930s. Today, mortgage lending guidelines have eliminated the toxic types of loans that got Wall Street and everyone else in trouble.
In fact, according to data from The Economist* home prices in San Diego have risen by nearly 80% in real terms from 1980 to 2015. Nationally values have increased approximately 17% during that same period. Los Angeles during that same period has seen prices more than double over the past 35 years. Remember, these figures are in inflation adjusted dollars.
The point is that over time home values will appreciate over time yet any particular property will appreciate at the very same rate regardless of how much was put down in order to buy and finance the home. The difference may lie in leveraging with as low a down payment as possible using today’s low interest rates and using the funds to acquire other higher earning assets.
Finally, liquidity is a factor. We mentioned earlier that tapping into the equity in real estate can be costly and time consuming whereas buying and selling other appraisable assets is relatively liquid. For example, someone owns a set of mutual funds currently valued at $250,000 and a home with $250,000 in equity. The individual can tap into the mutual funds for any and all of the balance and receive a wire in a bank account often same day with very little cost. The very same for individual stocks. So too for bonds, bills and treasuries. Corporate bonds as well. When an owner of any of these types of assets needs access to those funds either for the short term or permanently it’s very often just a few keystrokes away from accessing those assets.
Like we said previously, a low down payment option may not be a perfect fit for you. Even from a personal perspective while the investment math certainly makes sense for a particular situation someone just may not be all that uncomfortable with the idea and instead put as much money down as possible and that’s certainly alright. We realize there is a psychological decision sometimes regarding which loan type is the best and how to user personal assets in a real estate transaction. Even if a borrower evaluates a 10/1 hybrid where the interest rate on the loan will never change for at least 10 years, it’s just the idea of the unknown down the road that can create pause.
But let us provide you with some numbers and let you and your financial planner review the idea of putting less, not more down. The numbers typically speak for themselves and if it’s a good idea, we’d be happy to explore the option further with you.