Mortgage Reduction Secret Weapon: Your Down Payment Part 3of 3

In parts 1 and 2 we reviewed wealth principles, how a mortgage works and the conventional prepayment plans commonly available to consumers. Those prepayment plans pale in comparison to this one:

The Down-payment Secret Weapon

What is a down payment?

A down payment is typically a lump sum of money that a homeowner applies against the purchase price of a property. The loan amount is typically equal to the purchase price less the down payment. Homeowners make down payments because they feel they ought to and to lessen the payment shock of the mortgage. Banks want homeowners to have a down payment because it lessens their overall risk. If you could maintain foreclosure rights on a property by loaning a fraction of its appraised value, wouldnt you want to do that? That is what a bank wants to do.

Homeowners ought to have a down payment because a home purchase is an expensive transaction and once the excitement of the home purchase has passed, homeowners typically find that they are very cash poor forced to put unforeseen expenses on credit cards.

The amount available for down payment should be at least 20%. Given the expenses of owning a home, having a down payment of 10% means just barely getting into a home. Scraping together a down payment, barely qualifying for the monthly payment, then living in the home can create a level of stress that will make a homeowner regret ever purchasing the home. Although principal and interest payments may remain fixed homeownership costs are guaranteed to go up due to rising tax, maintenance and insurance costs.

Now even though I believe you should have at least 20% to put down on a home, I dont believe you should apply the down payment the way the bank wants you to.

For homeowners seeking to prepay their home loan and save massive amounts of money in interest payments. Their down payment is their secret weapon. Simply making the down payment the first payment on the loan will turn a 30 year mortgage into a 22 year mortgage saving thousands more than the bi-saver programs banks offer. The down payment, then will serve at least two purposes: 1) save massive money in interest payments 2) build equity in the home.

Why does this work?

Strategically applying your down payment works because of mortgage principles number 1 and 2 mentioned earlier in this series. Mortgages are front loaded meaning that the bank collects half of the total interest due in the first 10 years of the loan. With a fixed-rate loan, the principle and interest payments are fixed. The proportion of each payment that goes to interest depends on the unpaid principle balance at the end of each month. Applying the down payment to the first mortgage payment literally disrupts the mortgage shaving time and interest payments off of the front end of the loan. The best way to illustrate this is to use a mortgage calculator commonly available on the Internet. On a loan balance of $197000 a first principal payment of $19700 will drop the principal balance to $177300. The interest that would have been paid before the outstanding principle would have been reduced to $177300 is $94000. By strategically applying your down payment, that is $94000 that you dont have to pay.

As the illustrations below prove, strategically applying your down payment is a far superior equity and savings strategy than putting 10% down and taking out a loan for $177000. It is also a far superior strategy than putting 10% down and enrolling in a bi-saver program. In fact there is no need to ever enroll in a bi-saver program when you strategically apply your down payment. Applying 20% with the first payment does not deliver the bank for the buck that 10% does. Applying 20% however will deliver another $57000 dollars in savings and shave an additional 5 years off the loan converting a 30-year loan into a 17-18 year loan. Strategic application of 10% down provides the biggest return per dollar applied. It makes sense to hang onto the other 10% as a cushion or future investment.

One of the main reasons that people make a down payment is to lower the monthly payment. $127.78 is the difference in mortgage payments between a $197000 loan at 6.75 percent and $197000 less 10 percent down ($197000-$19700=$177300). There are an incredible number of things that can happen when you own your own home, which is why you should hold on to your capital. If $127.78 will make a payment unaffordable, then it is probably best to pass on the house until your financial situation improves.

We used this strategy in 2006 when we purchased the home we intend to retire in. The loan was an 80/20 loan with a blended rate of 6.77%. The 80/20 loan avoided PMI. By strategically applying the down payment, the 80% portion will be paid in 19 years and the 20% portion in 16 years.

About Private Mortgage Insurance;

The loan is collateralized by the underlying real estate. Private Mortgage Insurance (PMI) is a premium you pay to make sure the bank is reimbursed in the event of a default. The banks are double dipping here and it is unfair. The premium is typically $55 per month per $100,000 financed. There is specific law about private mortgage insurance and how you can petition to remove it. Through 2010 PMI is tax deductible. I have had PMI in the past and it was relatively easy to get rid of.

Will the bank let you use this strategy?

The short answer is that we did it and made our intentions clear when shopping for a loan. While we got our loan through the private sector, this strategy is very easy to employ using VA or FHA loans. We looked at all three types of loans before going with the private sector loan. This strategy does not work nearly as well if you have only 10% to put down and have to put at least 5% down to get a loan. In fact, under those circumstances, you are better off putting 10% down and enrolling in a bi-saver program. Remember that because of the expense of homeownership you should delay a home purchase until you have 20% down. If you have 20% down and the bank forces you to put 5% down you still win. By then applying 10% of the unpaid principal to the first payment you will put a total of 14.5% down, preserving part of your down payment and will save slightly more in interest costs over the life of the loan than if you had played the banks game and put 20% down and enrolled in a bi-saver program.

Here are the illustrations:

Home price is $197,000 20% ($39,400) = $210388.62 total interest payments at 6.75%

Home price is $197,000 20% = $157,600 loan amount. Bi-saver program = $160,673.16 total interest payments + fee expense for program

Home price is $197,000 5%(9850) = $187,150 loan amount. Apply $18,715 to the first payment = $160, 226.52 + 0 additional expenses. Using this method a homeowner would still have $10,835 dollars of their down payment to have as cash reserves.

The more philosophical answer is this: You shouldnt have to ask permission for how you spend your money.

A roof over ones head is a necessity; home ownership is merely one option that meets that need. As an investment or a forced savings plan, home ownership is a poor choice. Wait to purchase a home until you have sufficient capital reserves and can apply strategies to decrease your overall costs on the back end of the loan and preserve your wealth on the front end.