Mortgage borrowers with enough money to make a down payment larger than the minimum must decide whether to increase the down payment or pay points.
This is an investment decision that should be based on which option yields the higher rate of return.
- Borrowers with long-time horizons, who don’t have enough money to make a meaningful increase in down payment (see below), should consider paying points.
In today’s market, the 4.50 percent rate on a 30-year fixed-rate loan to a prime borrower could be reduced to 4 percent by paying 2.6 points — that is 2.6 percent of the loan amount. Over the next 12 years, that would earn a return of 11.5 percent. If the mortgage is terminated after five years, however, the interest saved would not cover the cost of the points, resulting in a negative rate of return.
- Investing a small amount in a larger down payment yields a modest return. A borrower putting 5 percent down who elects to increase the down payment to 6 percent or 7 percent earns a return equal to the mortgage rate, or just a little higher, regardless of how long the mortgage is in force. The return is a little higher than the mortgage rate because of upfront fees scaled to the loan amount.
- To generate a higher yield, the investment in a larger down payment must be large enough to flip the loan into a lower mortgage insurance premium or interest rate category.
Mortgage insurance premium categories, expressed in down payments, are generally 3 percent to 4.99 percent, 5 percent to 9.99 percent, 10 percent to 14.99 percent, and15 percent to 19.99 percent. Where lenders pay for the mortgage insurance and price it in the rate, they use the same categories.
If the borrower taking a 4.5 percent mortgage at zero points with 5 percent down raises the down payment to 10 percent, the loan shifts into the 10-14.99 percent mortgage insurance premium category. Since the premium is lower, the return on investment over 12 years rises to 7 percent.
- Increasing the down payment on a loan slightly larger than the conforming loan limit increases the rate of return.
The conforming loan limit is the maximum size mortgage that can be purchased by Fannie Mae and Freddie Mac. A loan for $453,101 will carry a rate about 0.25 percent higher than a loan of $453,100, which is the current maximum. Hence, a borrower contemplating a down payment that would result in a loan amount slightly above the conforming loan limit should consider raising the down payment by enough to get under the limit.
- Borrowers forced into a non-qualified mortgage earn the highest return on investment in a larger down payment.
Last week I wrote about mortgages that for one reason or another did not meet the requirements established by the Dodd-Frank Wall Street Reform and Consumer Protection Act for the standard mortgage designation.
One consequence of this designation is that we now have lenders specializing in non-qualified mortgages who operate in a manner very similar to subprime lenders before the financial crisis. One striking point of similarity is that mortgage insurance is not required but variability in interest rate associated with differences in down payment is very large. A result is that the rate of return to the borrower on an investment in a larger down payment is very high.
As an example, one lender of non-QM loans quoted 6.625 percent on a high credit score transaction with 10 percent down, and 5.375 percent with 20 percent down. The rate of return to the borrower on the down payment increase would be 12.2 percent calculated over 12 years. With a low credit score borrower, the rates were 8.375 percent and 7.375 percent, resulting in a return on investment of 15.9 percent.
The bottom line is that mortgage borrowers who fall into the highest price categories, whether because of their credit history, weak documentation or whatever, can earn the highest rate of return on investments in larger down payments.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.