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Importance of the Down Payment

Posted by  on Apr 16, 2009
 
It is imperative that when looking into mortgage and mortgage lenders that a buyer is familiar with the down payment and its importance in buying a home. To start, it is good to know that the down payment is the difference between the loan amount and the lower of sale price or appraised value. Borrowers have no down payment decision to make because they do not have the money for one.

Their challenge involves qualifying for a loan without a down payment, for which purpose excellent credit is critically important. Borrowers with enough money to make a down payment, who are not sure exactly how much to put down, do have a decision to make. It is similar to the decision about whether or not to pay points, in that it is best viewed as an investment decision.

Keep in mind that there are important differences, however, between investing in points and investing in a big down payment. One difference is in the amounts required. If you have surplus cash equal to 1% of the loan, you can earn a return of 20% or more by buying down the rate, provided you hold the mortgage for five years or longer. The same amount used to increase the down payment will only yield a return equal to the mortgage rate, or a little higher if you are also paying points, but well below the return on points.

To generate a higher yield from investment in a larger down payment, the investment should flip the loan into a lower mortgage insurance or interest rate category. Where lenders pay for the mortgage insurance and price it in the rate, they use the same categories. For instance, if a borrower taking a 6% mortgage at zero points with mortgage insurance considers raising the down payment from 5% to 7%, the loan will remain in the 5-9.99% mortgage insurance premium category. The premium will remain the same, and the return on investment will be limited to the interest saved on the reduction in loan amount, which is 6%.

In addition, it sometimes occurs that a borrower’s down payment results in a loan amount slightly above the conforming loan limit. If the increase in down payment from 5% to 10% in the previous example not only reduced the mortgage insurance premium but also brought the loan amount below the conforming loan limit, the rate would drop from 6% to about 5.625%. In such case, the return on the investment in a larger down payment would rise from 11.6% to 17.9%. When mortgage insurance is paid by the lender and incorporated in the interest rate, the return on an increment to the down payment that flips the loan into a lower rate category is highest when the initial down payment is low.

This is seen most graphically in the sub-prime market where risk-based pricing is pervasive. Investment in a larger down payment earns a return on investment about equal to the mortgage rate unless it drops the loan amount into a lower mortgage insurance premium or interest rate category, or below the conforming loan limit. This usually requires a down payment increase of 5% of property value or more.

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