Does an Oversized Down Payment Pay? - TheStreet

Today’s mortgage rates are low enough to make borrowers salivate. Freddie Mac (Stock Quote: FRE) says its survey puts the average 30-year, fixed-rate loan at 4.71%, the lowest in at least 38 years. The Survey puts the number at an enticing 4.955%.

The low rate presents borrowers with an intriguing question: Should you make a big down payment to keep your loan as small as possible? Or should you borrow every penny you can while rates are in the basement?

Most lenders today require down payments of 20%, while a few years ago it wasn’t hard to find a zero down-payment loan. A bigger down payment reduces the lender’s risk by ensuring a property could be sold for enough to cover the borrower’s debt.

Many borrowers struggle to come up with 20% down payments. But others have lots of savings, or substantial equity in the home they sell in order to buy a new one.

Deciding whether to put down 30%, 40% or 50% hinges on several factors.

Imagine a person who is buying a $400,000 home. This buyer could qualify for a $320,000 mortgage, putting down 20% or $80,000. But suppose the buyer could afford a $200,000 down payment, reducing the loan to $200,000.

Putting down an extra $120,000 is like investing that sum at a yield equal to the mortgage rate, since it would reduce the borrower’s interest costs. If the mortgage charged 4.8%, the bigger down payment would, in effect, earn 4.8%.

Over the long term, the borrower might well earn more than that in a good mutual fund investing in stocks. But there’s a risk of losing money in stocks, while putting the money into the home would provide a guaranteed 4.8% return.

Compared to other safe investments, 4.8% looks pretty good. According to the Survey, five-year certificates of deposit average just 2.253%, while money market accounts yield just 0.385% and savings accounts only 0.22%. A 10-year U.S. Treasury note yields 3.47%.

But money used for a down payment would be tied up until you sell the home, refinance or take out a home equity loan. Invest in bank savings or another liquid holding and you could get at the money quickly in an emergency or for a better investment. In good times, lots of corporate and government bonds pay more than 4.8%.

Finally, consider that an oversized down payment would reduce the size of your loan, minimizing your monthly payment and giving you a little more breathing room during a financial setback. At 4.8%, payments on a $200,000 loan would be $1,049 compared to $1,679 for a $320,000 loan, according to the Mortgage Loan Calculator.

Of course, if you did not make the oversized down payment you could have a $120,000 cash reserve to get through tough times.

Bottom line: Making a larger-than-required down payment is more likely to pay off financially when interest rates are high, not low. But keeping debts as small as possible can produce a lot of peace of mind.

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