For many homebuyers, scraping up a down payment take years of penny-pinching. But not for everyone. Many buyers have a chunk of change from sale of a previous home, inheritance or investment winnings.
For those in that enviable situation, the question is: What’s the best way to invest that money? Put it into the new home through a large down payment? Or make the smallest down payment required and invest the cash some other way?
The answer depends on the household’s investing skill, time horizon and stomach for risk. And the answer could change depending on the prospects for the housing and financial markets.
Still, a few basic considerations can make the decision easier.
[See: 11 of the Best Fixed-Income Funds to Buy.]
As the housing crisis recedes, more and more lenders will accept down payment of 10 percent, 5 percent or even less. But Richard Airey, a loan officer with First Financial Mortgage in Portland, Maine, says there are practical reasons to put at least 20 percent down.
“Assuming the borrower has the choice to put a large down payment due to investments or equity taken out of a previous home, the rule of thumb is that a down payment of 20 percent on a conventional loan results in the lowest interest rate and the lowest closing costs,” he says. “This also eliminates the need for costly private mortgage insurance.”
Standard wisdom holds that putting money into a home, through a large down payment, extra principal payments or improvements, makes sense in purely financial terms only if the return on this home investment beats what can be earned in an alternative like the stock market. If stocks rise by 10 percent a year and the home’s value goes up only 3 percent, stocks might be a better bet.
But it’s not that easy to measure the return on cash put into the home. That investment does, in effect, earn interest by avoiding interest on a loan. Putting an extra $20,000 into a down payment or extra principal payments on the loan allows the borrower to avoid interest charges on $20,000 that could be added to the mortgage. So if the mortgage charges 4 percent, that cash put into the home is “earning” 4 percent.
Stocks often offer bigger returns. But stocks are risky, while cash used to reduce interest charges gets a guaranteed return equal to the loan rate. So perhaps it makes more sense to compare the home return with that of an option with similar guarantees, like bank savings or yield on U.S. Treasury bonds. By that standard, earning 4 percent on money put into the home looks pretty good.
Of course, the conclusion might look different years down the road with different loan rates and higher yields on fixed-income securities, or a soaring stock market. If you could earn 6 percent on a Treasury or 20 percent on a stock five years from now, you might kick yourself for having locked up that money in your home.
Derek Hagen, founder of Fireside Financial in Minneapolis, suggests homeowners consider their comfort with various approaches to investing, since using a small down payment to free cash for investing really means borrowing to invest.
“Anyone who thinks they should make a smaller down payment strictly because they want to invest the difference should ask themselves if they would take out a loan and invest that money in the stock market — called leverage,” Hagen says. “If they wouldn’t leverage the market, they should put down a larger down payment.”
[See: 9 Ways to Invest in America With Bond Funds.]
While putting more down can get the borrower a lower loan rate and other savings, the homeowner should not opt for a big down payment if it will leave too little for emergencies, says Matt Hackett, operations manager at Equity Now, an online lender.
“It is certainly important to have an emergency fund, and closing on a home purchase with no reserves is a precarious position to be in, considering the likelihood that something goes wrong — a fridge or a hot water heater breaks,” he says.
For many homeowners, another consideration is how money put into the home will grow due to rising home prices. This involves something of a misconception, since the home will gain or lose the same amount regardless of whether the owner makes a large down payment or a small one.
In fact, many homeowners feel the math favors the small down payment. If you put down 10 percent and the home’s value grows by 10 percent, your equity is doubled. Put 20 percent down and it grows by only 50 percent, though the gain is the same in dollar terms. The smaller down payment also allows you to invest the savings in another way, adding to the gain. But if the home loses 10 percent, the 10 percent down payment is wiped out.
Experts say it’s a mistake to assume growing equity is the same as investment return. Equity is simply the difference between the property’s value and the debt. While it does go up as the home’s value rises, it also goes up as the owner pays down the debt, which is just moving money from one pocket to another.
Experts urge homebuyers and borrowers to also consider other features of their investment options, such as liquidity, or the ability to cash out when conditions change or you need money. With a stock, bond or mutual fund, it may take just a few mouse clicks to get cash or switch to a more promising investment. Getting cash out of a home requires selling or taking out a new mortgage or reverse mortgage. It could take weeks or months and incur a lot of expenses.
Finally, experts note that putting money into a home is not just a pure financial matter. A household with an uncertain income might opt for a large down payment to minimize monthly mortgage payments for peace of mind. And the homeowner approaching retirement might well prefer to put extra money into the home to enter retirement free of debt.
[See: The Best ETFs Retirees Can Buy.]
Many experts suggest it’s best to view the home as a home rather than an investment. After all, gains made on one home will likely be used to buy the next one, anyway. Home equity is not money in your pocket until you downsize.
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Should You Invest That Down Payment? originally appeared on usnews.com
