The Benefits of Having a Larger Down Payment
4th September 2014
Consumers face many decisions when looking to purchase a home. One of these many decisions include how large of a down payment to put down. Their down payment is the sale price less the loan amount. In the vast majority of cases, the potential home buyers must have their financial assets, at a bare minimum, be as large as the down payment they will make. Many consumers, despite having the capacity to put down more, put down as little as they can because they view a down payment as a loss instead of looking at it as the investment that it is. The nice thing about down payments is that the return on investment is 100 percent risk free. It is an investment that yields a return far surpassing anything else available to consumers.
If Bob is planning on purchasing a home for $200,000 financed, a mortgage of $190,000, priced at 4.25 percent and 1 point, his down payment of $10,000 is 5 percent of the price. He’s retaining another $10,000 in a money market fund currently yielding him less than 1 percent. However, if he uses that $10,000 instead to increase the down payment to 10 percent or if he can save that amount before the deal is made, his rate of return will be 7-8 percent, which would depend on how long he keeps the mortgage not to mention, there is no risk involved.
Where does the yield come from on a return derived from loan elimination? Part will come from the elimination of the $10,000 of mortgage loan on which he’d pay 4.25 percent and 1 point. He’ll retain the points and interest on the $10,000 he doesn’t borrow. If he keeps the loan for seven years, the component of the return is 4.43 percent. This may sound like a complicated concept but in reality it’s actually pretty simple. When 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 will include the points and interest you do not have to pay the lender on the $10,000 you do not borrow.
If we take a $190,000 loan with 5 percent down (let’s assume the borrower has very good credit) the monthly insurance premium is around $85. Now if we take an $180,000 loan with 10 percent down, the premium would be around $58. This reduction will increase the rate of return on the investment of $10,000 down payment to around 7.88 percent.
With a larger down payment, why would loan costs drop? Well, the answer is simple: The bigger the down payment, the lower the risk to the lender. So, if the borrower does fault, the likelihood that the debt would surpass that of the property value will be much less with a bigger down payment. Usually, a higher down payment shows that the borrowers are probably less likely to default as they demonstrated a budgetary discipline with their ability to save funds.
Saving for a down payment will be different depending on when you are looking to purchase. Potential borrowers who are actively looking and plan to purchase a house soon will base the decision on their current financial assets. Potential borrowers looking ahead to the future (where they’ll hopefully be in a better financial situation) need to develop a savings plan. In planning ahead, they should assume that the return they will earn on the savings is 1.5 times the home mortgage interest rate. (A conservative estimate of the rate of return on the savings when used as a down payment)
If you have been planning to purchase a home but have been unsuccessful at saving, it’s time to start now. If you typically view saving as a sort of residual thing, as in whatever remains unspent at the end of the month will be saved, then in doing this you are making saving the lowest priority and will find it quite difficult to reach your goal of purchasing a home. The number one secret to successfully saving is simply making it the highest priority in your budget. You’ll need to sit down and decide how much of your income you’ll be able to afford to save and create a separate account solely for this purpose. Then immediately after you are paid, write a check out for that amount and deposit it into the account. If you have the ability to set up an automatic deposit of this amount into the account with each paycheck, then that’s even better. You’ll be surprised how quickly your dreams of homeownership become reality when you make this your number 1 priority. If you have any questions, would like a quote or to get pre-approval, give me a call and let me know how I can help.
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Peter Thompson 630-479-6424
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