It’s a quandary most new home buyers face. You have limited cash available. Is it better to use your savings to buy down your interest rate, or to make a larger down payment? How do you decide?
It depends, of course.
Using the money for a larger down payment may help you avoid mortgage insurance (MI), or at least lower its cost. Using your savings to buy down your interest rate will save you money for the life of the loan. To decide which path is right for you, keep these facts in mind:
- The price of mortgage insurance goes up as the loan-to-value ratio (LTV) increases, but not in a linear fashion. Rather, it increases in increments, typically of 5 percent. So, at 80 percent LTV your MI is zero. At 80.01 percent you pay fairly low insurance, until 85 percent; then it goes up a bit. The rate stays steady until you hit 90.01 percent LTV where it jumps more noticeably, and at 95.01 percent or above you’ll pay the highest rate.
- Mortgage insurance isn’t permanent on most loans. (FHA loans are an exception today.) As you make payments and when your LTV goes below 80 percent of the then-current value of the home, you may ask the lender to cancel your mortgage insurance. Alternatively, once the LTV declines below 78 percent of the original purchase price, the lender must by law terminate mortgage insurance.
- Most MI contracts, however, require you to carry MI for at least two years, regardless.
- If you use your cash to buy down your interest rate, the savings are permanent; they last the life of the loan. But how long will you keep the loan?
- Depending on the day, the interest rate and the lender it typically costs from 0.25 percent to 0.75 percent of the loan amount in up-front fees to reduce your interest rate by 0.125 percent. So, on a $100,000 loan, you would spend between $250 and $750 up-front to reduce your interest rate by 0.125 percent.
- You can’t spend all your cash on the transaction. When you close escrow you should not be flat broke and busted. You must have some reserves left over. Typically lenders require that you have at least enough to cover three months of housing costs. (Principal, interest, taxes, insurance, and mortgage insurance and HOA dues, if applicable.)
Keeping these points in mind, let’s explore how to make this decision.
Assume you are buying a $200,000 home, and you have $33,000 in available cash, plus enough for other closing costs and reserves. Should you put down all $33,000? Or hold some of it back to spend on buying down the interest rate?
Remembering that the rate (and thus the cost) on mortgage insurance changes at certain thresholds, you can see that it won’t make any difference to your MI rate to put down more than 15 percent, unless of course you can put down 20 percent. Since you can’t, it would probably make sense to put down only $30,000 – 15 percent - and reserve the other $3,000 to buy down the interest rate.
Is that true every time?
Well, not necessarily. It’s important to look ahead to the future. What are your plans? If you think you might sell and move up within a few years, you might not recover the money used to buy down the interest rate. In that case, you’ll save more by using the money for a larger down payment.
It’s important to look ahead to the future. What are your plans? If you think you might sell and move up within a few years, you might not recover the money used to buy down the interest rate.
What if you don’t have plans to move soon, and anticipate having windfall income, such as large bonuses, stock option payouts or an inheritance? Then it might make more sense to use your available cash to buy down the interest rate as far as you can, because that represents a permanent savings, and when the windfall income arrives you can use that to buy down your loan amount far enough to get rid of mortgage insurance.
Alternatively, you might consider using two loans in that scenario: an 80 percent first mortgage, plus an equity line to cover the extra five percent. When your windfall income arrives you can pay off your equity line and still have access to it in the event you need cash later. Notice, however, that because the first mortgage is at 80 percent, there is no MI!
The point is that there is no “one right way” to use your cash. To determine what is right for you, you must thoughtfully examine your own situation and near-term plans, and then examine the financial ramifications of your various options.
A competent, ethical loan officer should be able to guide you through this process and help you with the analysis. (If not, get another one!)
And isn’t it nice to know you have options? Happy house hunting!