More down payment versus more house

I have written about this question in the past, and recently decided to take a fresh look at it. The conclusion I reached was that my previous articles on the subject were incomplete, and in some circumstances could be misleading.

My previous articles emphasized the role of down payment increases as an investment, earning a rate of return that was comparable to the return on other investments. The return on an investment in a larger down payment has three major components:

• Monthly payments are lower because of a smaller loan amount, and perhaps a lower interest rate and mortgage insurance premium.

• Upfront fees calculated as a percent of the loan amount, such as points, are lower because the loan amount is smaller.

• The amount owed at the end of the period is smaller because it begins smaller and is paid down more quickly.

There is no risk of loss on investment in a down payment, but there is also no liquidity — an investment in down payment is not salable. The term is the life of the mortgage, which is not known in advance, but must be estimated by the buyer.

I recently calculated the rate of return over eight years for different down payment increases on a $400,000 house purchase, using the best conventional mortgage prices quoted by the lenders who deliver their prices to my website daily. Conventional loans with down payments of 5 percent, 10 percent and 15 percent carry private mortgage insurance. I found that increasing the down payment from 5 percent of sale price to 10 percent, from 10 percent to 15 percent, or from 15 percent to 20 percent yielded a return of 6 percent to 6.5 percent. Readers who want to check this out can use calculator 12a on my website.

A return on investment of 6 percent to 6.5 percent may seem modest — until you realize that it is a riskless investment. In terms of safety, it is comparable to Treasury securities. In today's market, an eight-year Treasury security yields about 2.2 percent.

A homebuyer in a position to make a down payment of varying size actually has two investment options. One is to make the larger down payment, as noted above.

The second option is to use the incremental down payment to purchase more house. My previous articles neglected this option.

Here is an example. Jones has $20,000 available for a down payment. If he purchases a $200,000 house, he can put $10,000 down (5 percent), or $20,000 down (10 percent), viewing the additional $10,000 as an investment. His second option is to use the entire $20,000 to purchase a $400,000 house with 5 percent down. Instead of investing in a larger down payment, Jones would be investing in more house.

Of course, this example of investing in more house is oversimplified. To implement it, Jones has to have the income needed to pay a $380,000 mortgage, and the additional cash needed to pay higher settlement costs. Nonetheless, the basic point, that a lower down payment may encourage the purchase of a more costly house, is correct.

The clearest case where a buyer who can qualify for the larger mortgage required is better off financially in purchasing more house than in making a larger down payment is when the expected appreciation rate of the home exceeds the mortgage rate. In that situation, the expected additional house value exceeds the additional interest charges, and may do so even if the borrower is paying a higher rate on the lower down payment mortgage.

For example, if the mortgage rate with 10 percent down is 4 percent and the expected home-appreciation rate is 5 percent, the buyer electing to purchase a $400,000 house with 5 percent down rather than a $200,000 house with 10 percent down would be justified in paying 4.5 percent for the mortgage because of the additional appreciation. If the appreciation rate is 6 percent, he would be justified in paying 5.1 percent on the mortgage. Note that this calculation does not include any incremental value associated with having a more valuable house.

Macroeconomic theory says that interest rates are always higher than expected price increases, which may be why my earlier articles on down payments left out the option to purchase more house. The general rule, however, does not necessarily hold for the housing sector.

The low mortgage rates in recent years combined with high property appreciation rates in some areas of the country mean that some house purchasers who can afford the more costly house made possible by a smaller down payment, may do better investing in greater house appreciation than a larger down payment. But it is a small group, and one of the reasons is that the appreciation rate is a forecast subject to error. The rate of return on a larger down payment involves much less uncertainty.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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