Q&A: What's a good down payment size?

This is actually quite a complicated question. For one, things can change rapidly. For example, the interest rate penalties for high loan to value (LTV) ratios used to be higher. I believe they have been reduced in many cases as part of the effort to improve the housing market. On the other hand, a lot of loan regulations have gotten stricter to avoid bad loans entering the market again. Basically, rate changes related to your LTV need to be discussed with your lender.

Private Mortgage Insurance (PMI) still needs to be purchased when your LTV is greater than 80%. PMI is typically equivalent to a 0.50% to 0.75% interest rate hike for the period it needs to be paid. Some lenders advertise PMI-free loans even when your LTV is greater than 80%. The PMI still has to be purchased, but for these loans the lender buys it. They will pass this cost on to you via a higher interest rate - there is no such thing as a free lunch. Because your interest rate won't change for the life of a standard 30-year fixed rate mortgage, this interest rate, even if it results in lower monthly costs than buying PMI, could very well cost you more in the long run. Again, go over the details with your lender.

When it comes to deciding between making a larger down payment and buying PMI (or accepting a higher interest rate to cover PMI expenses), you have to look at the best use of your money. My previous post on whether or not to prepay your mortgage could be helpful in evaluating your options. Personally, I would rather avoid PMI than invest a few thousand dollars, say. Whatever you invest that money in would have to earn you more than the PMI payments and extra principal and interest payment amount (minus taxes on the interest and PMI, since PMI is tax deductible like mortgage interest). In fact, this should be considered an addendum to my previous post: The return needed to overcome PMI probably warrants paying extra principal at least until you reach 80% LTV. Psychologically, I just hate the idea of paying private mortgage insurance because it only benefits the lender.

Paying extra principal at the beginning such that you have less than 80% LTV ratio mostly follows my previous post's recommendations. The only difference is that the extra principal in this case does reduce your minimum monthly payment. When determining the terms of your loan, though, you have another option to reduce your payment: you can pay points to reduce your interest rate. As you can see using my refinancing calculator, reducing your interest rate can reduce the interest portion of your payment more than the total monthly payment amount in some cases. You have a choice in which number you use in determining your break even point, but obviously the total monthly payment might be all you care about.

I would make a point-paying calculator, but the cost of each interest rate reduction isn't always the same. For example, it may cost you half a point to move from 5.000% to 4.750%, but another half a point to move from 4.750% to just 4.625%. The user interface of such a calculator would be clunky at best. You can use the refinancing calculator fairly easily to get individual values and compile your own table of break-even times, though. Just find a payment amount for a 0-point loan and plug that into the current loan information fields. Then zero out the closing costs and adjust the points value and find the resulting interest rate entry.

Overall, I would tend toward a 20% down payment if you can afford it so you can avoid PMI. After that 20%, paying points will usually reduce your monthly payments more than extra principal. I paid half a point on my first loan, I think, and zero points on my refinance, other than the quarter-point fee I paid to waive escrow. For the most part, it comes down to what you feel comfortable paying up front versus owing later. I'm not sure there's ever a clearly wrong decision!

Mortgage Refinancing

I submitted my info to LendingTree.com a couple days ago and have been talking with mortgage people all yesterday. At the moment, the best rate I can get is 5.125% with 0 points. My current rate of 5.75% is already a decent rate, but refinancing would lower my minimum monthly payment by about $100, while increasing the amount of principal I pay each month. I would recoup my refinancing costs inside a year, but I'm still not sure if it's worth it.

The worsening economy hints that interest rates may fall further, but every month I wait, I'm effectively adding $100 to my closing costs. I'm not sure if refinancing works the same way as a first mortgage, but with my first one, it was best to close at the very end of the month to reduce the amount of prepaid interest you have to pay. Sometime next week I think I might be going to the Community Home Lending offices and discussing the timing of everything. It may be that I have a few weeks to think about it just waiting for an optimal closing date.

What are other people's thoughts on refinancing? Any questions I should definitely ask?

Prepaying Mortgage vs Investing

I've been debating on whether or not to buy points on my mortgage, and then whether I should pay extra on the principal or not.

Let's tackle the second question first. There are many issues that disappear when you properly phrase the question. So, we'll have the goal of maximizing net worth at the end of the mortgage term.

House Appreciation: No matter how much of the house you own, it will appreciate at the same rate. Paying down the principal does not affect the value of your house. The only time paying down the principal helps with regards to house appreciation is if you sell it earlier or refinance the loan. You will then get more money from the sale or have to finance less. In my case, where I'd be more likely to keep the house and rent it out after I move, this is completely irrelevant to my final net worth.

Rate of Return: The rate of return on an investment makes all the difference. If the interest rate on the loan is 6% (as mine is likely to be), then paying down principal is effectively a 6% investment. This beats CDs and high-yield savings accounts, and is a guaranteed rate of return. However, the stock market in general tends to beat an 8% rate of return. For instance, last year I made about 14%. Currently, my E*TRADE account has earned 8.88% for the year (which is not a balanced account, and so fluctuates wildly).

Tax Considerations: Money invested is subject to income tax or capital gains tax. Assuming a 25% effective tax rate, my investments must earn a (.06/.75) = 8% rate of return. Well, my investments usually do earn 8% or greater! Plus, paying down principal reduces the amount of interest you pay, which increases your tax burden (interest being deductible).

Points: Buying points is an investment in a lower interest rate and a lower monthly payment. What is its rate of return? The value of a point varies over time and over the interest rate scale. For instance, currently moving from 6.125% to 6% costs .375 points, while moving from 5.875% to 5.75% costs .75 points. At 6%, my $232,000 loan has a monthly payment of $1,390. At 6.125%, it goes up to $1,410. 0.375 points costs me $870, and saves me $20/month, or $240/year. This is effectively a 25% return on investment. Given this new outlook on the value of points, I will need to talk to my mortgage guy again and figure out what is going on in more detail. Not every company has the same point scale, so it may just be that right now E*TRADE happens to have a favorable points system.

The other issue with points is that it also reduces the interest paid, and therefore increases your tax burden. Even still, the numbers above make it seem to be a solid investment.

Psychology: Even though paying down principal is logically a fairly conservative investment, there are a number of psychological advantages. First and most importantly, it feels good to not have so much debt, and to not have so many years left on the mortgage. Second, the more equity built, the more you feel like you have flexibility to sell or refinance. We'll see what I end up doing after my cash flow stabilizes (i.e., after I finish buying appliances, televisions, and furniture).

Mortgage options

I had a meeting with my mortgage representative on Thursday evening. It was a pretty standard meeting where he went over what he could offer, what all these papers in the loan application were for, and what I could expect in the next couple weeks. It looks like my closing costs will be slightly higher than what I can get online, but my interest rate will be on the lower end of the spectrum.

I don't feel too bad about paying a bit extra though, for a few reasons. One, and least importantly, he's my dad's friend and they have a group lunch every third Thursday. Two, I will have someone to work with in person. Three, he told me about closing at the end of the month instead of the beginning to avoid what would effectively be an interest-only payment on the first month. Four, he claims to be keeping an eye on the rates and corresponding market, and that he'll call me and tell me when he thinks is the best time to lock in the rate.

So, I've moved up my closing date to April 30th instead of May 3rd. I've officially applied for the loan. I should be getting 6% or less. It's one of those situations where I hate how the market only adjusts in 1/8% increments. I'm not paying for any extra points, as it would take me 8-10 years of saving the monthly payment reduction to break even on the cost. Given inflation and the like, I think I'm better off keeping the cost of the points where it is - invested in various things.

I'm hoping to do an analysis soon of whether or not you should pay extra every month in order to pay down the mortgage faster. So, look forward to that.

Financial Benefits to Homeownership

I've been compiling a list of benefits to owning my own home. The list is a bit longer than I expected, actually.

• Interest paid is tax deductible. Based on a $300,000 home value, this will be about a $13,500 deduction, which is about $3375 in saved taxes. Of course, this benefit diminishes over time.
• PMI premiums are deductible. This will not apply to my house purchase, as I plan on putting a full 20% down, but it's an added bonus, if you have to pay for PMI.
• Home appreciation. When I first buy my house, I will own 20% of it. However, any increase in value becomes my profit as though I owned the entire house.
  
• Immune to inflation. My mortgage payments will end up being rather large, given $240,000 in debt. But, this payment will not change. As time progresses and money becomes less valuable, my mortgage payment just gets easier.
  
• Rental income. Being single, I have the flexibility to rent out rooms in my house. While this probably isn't as financially secure as having a wife with a second income, it certainly doesn't hurt anything.
• Credit building. Due to my parents including me on their credit cars for the past 8 years or more, I have an excellent credit score of around 794. I can claim virtually no credit in this achievement, but it's kind of cool. The point, though, is that making regular payments on time helps your credit score.
• As opposed to paying rent. When you pay rent, your money goes to the landlord (which I will be!). When you make your mortgage payments, you build equity. You become a little more your own landlord every month.
• Tax deductible property taxes. Yep, property taxes are tax deductible, too. Of course, you still have to pay them.
• Points are tax deductible. If you improve your interest rate, points are tax deductible. Which is kind of like getting 25% off the cost of points. Not bad.

Did I forget anything? I feel like I did. Leave a comment and notify me!