Mortgage options -- thoughts?

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Topic Author
eddiejov55
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Joined: Mon Jan 09, 2012 9:01 am

Mortgage options -- thoughts?

Post by eddiejov55 »

I am 32 and about to become a first time home buyer. The housing price is $225,000. As a good boglehead I have saved 20% for a downpayment. However, the mortgage rates that we are being offered are making me question whether I should put down LESS money and keep more cash on hand? We have about $70,000 saved up between our house down payment fund & our emergency fund. Below are the 30-year rates we are being offered -- each down payment option avoids PMI by a slight rate increase:

Option #1 = 3.50% with 20% down payment ($45,000) and monthly payment of $807
Option #2 = 3.75% with 10% down & no PMI ($22,500) and monthly payment of $936
Option #3 = 3.85% with 5% down & no PMI ($11,225) and monthly payment of $1003

What are your thoughts? Should I proceed with the 20% down payment? Or is it worth considering the 5% down payment option and invest the $33,000 difference? At the base of it all, the home buying process is overwhelming and a fresh outside perspective would be appreciated!

=============================================

For full disclosure -- some stats below:

Combined Income: $150,000
Debt: $15,000 student loan

401(k): $155,000 (max out each year)
Roth IRA: $85,000 (max out each year)
House Downpayment: $50,000
Emergency Fund: $20,000
Stock Grants: $40,000
Grt2bOutdoors
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Re: Mortgage options -- thoughts?

Post by Grt2bOutdoors »

If you go with either the 10% down or 5% down, you would have to generate pre-tax returns on investing the difference of roughly 7% and 6.7% for each of those options to make it worth your while. I would put down the 20% and save the money upfront in the monthly payments. If you don't feel comfortable then wait a little longer until you accumulate a bit more cash. Personally, I would not want to buy (ahem, rent) a home with such a low down payment amount.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
Topic Author
eddiejov55
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Re: Mortgage options -- thoughts?

Post by eddiejov55 »

Thanks for the response!
Beantown85
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Re: Mortgage options -- thoughts?

Post by Beantown85 »

I agree with Gr2bOutdoors. PMI is never a good move if you can avoid it (which you can). Considering how low interest rates are, you can make a good argument for putting down no more than 20%, but getting to that 20% to avoid PMI is key (even if the rates were the same, which they're not, only making 20% down even more of a slam dunk).
Topic Author
eddiejov55
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Re: Mortgage options -- thoughts?

Post by eddiejov55 »

Beantown85 wrote:I agree with Gr2bOutdoors. PMI is never a good move if you can avoid it (which you can). Considering how low interest rates are, you can make a good argument for putting down no more than 20%, but getting to that 20% to avoid PMI is key (even if the rates were the same, which they're not, only making 20% down even more of a slam dunk).
Thanks for the feedback beantown.
finley
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Re: Mortgage options -- thoughts?

Post by finley »

what is the interest rate on your student loans? And are you still able to deduct its interest? If the interest rate is high enough, you could make an argument to only put 10% down and pay off the student loan. I would not put 5% down. After putting that little down, you would be very close to having negative equity in the home considering fees it would cost if you needed to sell the house for whatever reason.
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eddiejov55
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Re: Mortgage options -- thoughts?

Post by eddiejov55 »

finley wrote:what is the interest rate on your student loans? And are you still able to deduct its interest? If the interest rate is high enough, you could make an argument to only put 10% down and pay off the student loan. I would not put 5% down. After putting that little down, you would be very close to having negative equity in the home considering fees it would cost if you needed to sell the house for whatever reason.
Interest rate on the loan is 3.8%. But I've been paying $500 per month against the loans so once these are gone it would free up another $500 per month.
dickenjb
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Re: Mortgage options -- thoughts?

Post by dickenjb »

What is the interest rate on the student loan?

Might make sense to put less down and pay off the student loan.

Even if the rate is the same, you may be able to deduct mortgage interest but not student loan interest (depends on current and future income).

Edited to add:

OK I see you have provided that info.

Seems to me you could either pursue #1 and continue to aggressively pay down student loan at $500 a month; or put down $35K (no one says you have to put down only 5/10/20%) and pay off student loan now (modified option #2). I lean towards #1 only because you might find yourself in this house for a lot longer than planned and you can lock in the lower rate.
Outer Marker
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Re: Mortgage options -- thoughts?

Post by Outer Marker »

20% down. In fact, with your high income and low purchase price relative to that income, you should be comfortably able to handle the payments on a 15 year loan, and still max out savings and pay down debt. I would do that. 15 year loans can be had at well under 3%. Having a paid off house early in life gives you stability and improves options. (for example, you would be able to pay college tuition out of curent income instead of a mortgage, or you may want a differnt and lower stress occupation in your 50s.)
strafe
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Re: Mortgage options -- thoughts?

Post by strafe »

Grt2bOutdoors gave you the best answer. You have to look at the marginal cost of borrowing part of the down payment. You have to think of it as two loans -- the first 80% and then the amount beyond that.

The marginal cost of borrowing beyond 80% LTV is approximately the following depending on your marginal income tax rates:

0% bracket / ignoring tax deduction: 6% interest
15% bracket: 5% interest
25% bracket: 4.5% interest
28% bracket: 4.3% interest

You have to decide whether it's worth borrowing at those rates, particularly compared to your student loans.

I wouldn't worry about the negative equity issue that others brought up. If your house drops in value, it drops in value. Whether you make up the shortfall when you sell with savings vs. home equity is immaterial.
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Toons
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Re: Mortgage options -- thoughts?

Post by Toons »

I would prefer the largest down payment with the lowest monthly
payment, 20%. If I had more cash available I would apply it
and make an even larger down payment. :happy
Work on getting rid of the student loan
"One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity" –Bruce Lee
Topic Author
eddiejov55
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Re: Mortgage options -- thoughts?

Post by eddiejov55 »

strafe wrote:Grt2bOutdoors gave you the best answer. You have to look at the marginal cost of borrowing part of the down payment. You have to think of it as two loans -- the first 80% and then the amount beyond that.

The marginal cost of borrowing beyond 80% LTV is approximately the following depending on your marginal income tax rates:

0% bracket / ignoring tax deduction: 6% interest
15% bracket: 5% interest
25% bracket: 4.5% interest
28% bracket: 4.3% interest

You have to decide whether it's worth borrowing at those rates, particularly compared to your student loans.

I wouldn't worry about the negative equity issue that others brought up. If your house drops in value, it drops in value. Whether you make up the shortfall when you sell with savings vs. home equity is immaterial.
Thanks for the post and the additional way of looking at the information. Here is where I get hung up: If I put down 5% and invest the $33,000 -- assuming growth of 7% per year then I turn this into (ballpark) $235,000 over 30 years. If I put down 20% I would save $200 per month in the mortgage payment + interest, then I could potentially turn that into $225,000 over 30 years using the same logic as above.

At worst, it looks like the strategies are even...assuming I invest the $33,000 diligently and invest the $200 per month savings diligently. But I think that I am going wrong somewhere in my logic. I'm clearly having "writing large check" anxiety as the most expensive thing I ever purchased was an engagement ring...and that was a no-brainer that has produced a massive ROI :)
ResNullius
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Re: Mortgage options -- thoughts?

Post by ResNullius »

Unless you pay 20% down, the bank likely will require you to purchase mortgage insurance, which can add quite a bit to your monthly payment. Mortgage insurance is like term life, only it cost about 5 times as much. You want to avoid mortgage insurance whenever possible. If you want insurance, pay the 20% down, then buy your own term insurance. You'll save a lot of money. Good luck.
Beantown85
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Re: Mortgage options -- thoughts?

Post by Beantown85 »

eddiejov55 wrote:Thanks for the post and the additional way of looking at the information. Here is where I get hung up: If I put down 5% and invest the $33,000 -- assuming growth of 7% per year then I turn this into (ballpark) $235,000 over 30 years. If I put down 20% I would save $200 per month in the mortgage payment + interest, then I could potentially turn that into $225,000 over 30 years using the same logic as above.

At worst, it looks like the strategies are even...assuming I invest the $33,000 diligently and invest the $200 per month savings diligently. But I think that I am going wrong somewhere in my logic. I'm clearly having "writing large check" anxiety as the most expensive thing I ever purchased was an engagement ring...and that was a no-brainer that has produced a massive ROI :)
Comparing a guaranteed interest rate on a mortgage to an expected return on investment of 7% is nowhere near a fair comparison. These strategies aren't even, as one incurs a ton of risk in attaining that 7%, the other is guaranteed.
MGBGTV8
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Re: Mortgage options -- thoughts?

Post by MGBGTV8 »

According to my math- Investing the extra 22,500 in your down payment (increasing from 10% down to 20% down) reduces the interest paid on the balance by about $450 the first year, which equates to a 2% return on your extra investment. That's about the same as a long term CD.

The extra cash flow was $125/month. Remember that less mortgage payment lowers your theoretical needs for an emergency fund slighty, as well.

I would look to minimize the interest paid. I'll second the comments on the 15 year mortgage from "Outer Marker."
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nydad
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Re: Mortgage options -- thoughts?

Post by nydad »

re: 15 yr vs 30 year, I did a comparison using the mortgage professor's site, looking at a 30 year fixed at 3.5% and a 15 year fixed at 2.75% (which is close to today's wholesale rates with a 0.25% markup).

On a $100k loan, you can pay an extra $229.58 per month in principal and pay off the 30 year loan in the same amount of time, for the same monthly payments, as a 15 year fixed, and your total cost over the 15 years is $6.8k (or ~$450/year).

In exchange for that $6.8k in extra interest in the best case, you are paying for the right to *not* pay an extra $229/month, if you so choose. So it just depends on your own cashflow, and whether a 15 year where you have to pay the higher amount each month is a better overall deal than a 30 year, which has some flex if you want to ramp up payments, but might need to ramp them down later for some reason or another (job loss, etc)
Topic Author
eddiejov55
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Re: Mortgage options -- thoughts?

Post by eddiejov55 »

Thanks for all of the responses and fresh perspectives!!
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Watty
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Re: Mortgage options -- thoughts?

Post by Watty »

eddiejov55 wrote: Thanks for the post and the additional way of looking at the information. Here is where I get hung up: If I put down 5% and invest the $33,000 -- assuming growth of 7% per year then I turn this into (ballpark) $235,000 over 30 years. If I put down 20% I would save $200 per month in the mortgage payment + interest, then I could potentially turn that into $225,000 over 30 years using the same logic as above.

At worst, it looks like the strategies are even...assuming I invest the $33,000 diligently and invest the $200 per month savings diligently. But I think that I am going wrong somewhere in my logic. I'm clearly having "writing large check" anxiety as the most expensive thing I ever purchased was an engagement ring...and that was a no-brainer that has produced a massive ROI :)
The problem with your logic is that you will not get the average return each year and in some years there will be inevitable occasional significant declines in your investments.

If one of these happens early in the mortgage you will end up way behind and have a hard time catching up.

For example in rough numbers if there is a 15% decline(it could easily be even worse) then your $33,000 would decline to be about $28,000 but you will also be paying an extra $200 a month on the mortgage, $2,400 a year, so you would be down to $25,600 at the end of the first year. To get even the next year you would have to earn an additional $7,400 to get back to $33,000 but you would also be making another $2,400 in mortgage payments so you would need to earn a total of $9,800 in year two to break even.

Compared to the $25,600 investment the $9,800 is a 38% gain that you would need to just break even in the second year if you have just a 15% decline the first year.

You could also get a back to back down years early in the life of the mortgage.

With taxes, compounding, and paying down the principal this gets more complicated but the odds of having a few bad years early on are pretty significant so using the mortgage for leverage is a lot more risky than it might sound.

I would go with the 20% mortgage and also start saving in a "mortgage freedom fund" and put some money into it each month then you can pay the mortgage down or completely off sometime in the future if it makes sense then.
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DiscoBunny1979
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Re: Mortgage options -- thoughts?

Post by DiscoBunny1979 »

For me, it's simple. The goal is to save money, not necessarily make money. Therefore in order to save money, eliminating PMI by putting 20% down is the answer. The other answer to saving money is a 15 year fixed that saves huge interest compared to a 30 year fixed.

I can understand the anxiety about writing a big check, but eventually the house with have equity, far beyond that 20% down option, and therefore, you have to be comfortable at some point of having that $$ in the house - whether it be with the down payment or over time by paying down the mortgage. On my current home, I originally put 30% down and took out the 15 year fixed and am very glad I did. Putting extra into principal is really paying down the note.

The only thing the OP should be concerned about is whether there is a large enough 'emergency' fund to cover household unexpected needs. For instance, just paid for a new washer and dryer - wanted a good quality pair - for about $1800. Things can add up quickly on a want list and on a need list. Before you go for the purchase, make sure you've identified the needs and wants and totaled the cost for both categories. Prioritize the list(s) and make a game plan to accomplish such purchases and improvements.

You'll probably find like I have that although putting the smallest amount of money down sounds good (with the extra in the bank), it's a better feeling to know that the house has less to be paid off while you make improvements. If you pay only 5% down with a 30 year fixed and use up all other savings (not investments) to pay for improvements, then you really won't feel like you're making any progress - just getting deeper into debt - as a house can be a cash cow. Just my two cents.
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eddiejov55
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Re: Mortgage options -- thoughts?

Post by eddiejov55 »

Watty and DiscoBunny - thanks for the responses. It is great advice to look at the purchase as how to save money vs. how to make money. Fresh perspectives are always appreciated.
mikep
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Re: Mortgage options -- thoughts?

Post by mikep »

ResNullius wrote:Unless you pay 20% down, the bank likely will require you to purchase mortgage insurance, which can add quite a bit to your monthly payment. Mortgage insurance is like term life, only it cost about 5 times as much. You want to avoid mortgage insurance whenever possible. If you want insurance, pay the 20% down, then buy your own term insurance. You'll save a lot of money. Good luck.
PMI is not life insurance. Its only insurance to protect the lender if you don't pay your mortgage.

Lenders typically offer another product like mortgage life insurance which matches the description you provided, but is separate insurance than PMI and I agree you don't want this either. However this offer usually comes 1-2 months into the mortgage and is completely independent from the down payment amount.
nomadgecko
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Re: Mortgage options -- thoughts?

Post by nomadgecko »

Go for the 20% down payment, avoid the PMI, and call it a day.
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