Money Talks, So Should You

Small down payments come with pros and cons

Jeff Brown
by Jeff Brown, MainStreet contributor

A growing number of reports say lenders are granting mortgages with down payments of 10 percent or less — good news for borrowers unable to meet the 20 percent requirement that’s been all too common in recent years.

So here’s the question: If you can afford a big down payment but have a chance to make a small one, what should you do?

READ: Take these features into consideration when buying a home

There’s no pat answer. It depends on factors that vary with each borrower.

First the numbers, which are dramatic. LendingTree, the loan-shopping site, says that from Jan. 1 through April, 33 percent of the mortgage offers made by lenders on the site allowed down payments of 5 percent to 10 percent. Only 14 percent of offers required so little down in the comparable period last year, and just 4 percent in 2011.

Especially striking are the figures for down payments of less than 10 percent: 18 percent of all offers this year versus 6 percent last year and 1 percent in 2011.

In deciding whether to make a large down payment, the first issue is what else you might do with that money if it were not put into the home. If you bought a $400,000 home, 5 percent down would be $20,000, while 20 percent down would be $80,000 — a whopping difference. An immediate need such as a college tuition payment would make the smaller down payment more appealing. And it always makes sense to have a healthy rainy-day fund rather than tie up money in a house.

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But if that $60,000 were not needed right away, the key issue would be investment return. Cash used for a bigger down payment earns a return equal to the mortgage rate, since it allows the homeowner to avoid that interest payment. So if the mortgage charged 3.5 percent, that’s what the $60,000 would earn.

That’s not bad for a guaranteed return, given today’s low rates on bank savings and bonds, but it’s low compared with recent returns on stocks. Keep in mind that the down payment would be locked into the home for as long as you had the loan.

Second issue: how well could you afford the bigger monthly payment that comes from putting very little down. A $320,000 loan at 3.625 percent, a deal currently offered by Wells Fargo, would charge $1,459 a month in principal and interest, while a $380,000 loan at the same rate would cost $1,733. The lower payment would be nice if money got tight.

Next: would the lender require private mortgage insurance if you made the low down payment? Wells Fargo would require a monthly mortgage insurance payment of $212 for the $380,000 loan, but none for the $320,000 loan.

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That’s an annual rate of 4.24 percent of the $60,000 saved through the lower down payment. So if you put the minimum down, this charge would wipe out a lot of your earnings from investing that money elsewhere, perhaps all of them. Your investment would have to earn more than 4.24 percent to justify this option.

Finally, see how the low down payment might affect other loan features, such as the loan rate and points, which are upfront interest charges. In the Wells Fargo example, either option comes without points, and the rate is the same. But you have to check, as not all lenders will see it that way.

Also, the Wells Fargo example assumes the borrower has excellent credit.

If yours is not that good, you’d probably find the terms aren’t as good, either.

 

For the past 20 of his nearly 40 years in journalism, Jeff Brown has written about personal finance, economics and the financial markets. He has been a staff writer at The Philadelphia Inquirer and other papers, and in his six-year freelance career has been a columnist for TheStreet.com and the Nightly Business Report on PBS and blogged for The New York Times, MSNBC.com and other Internet sites.