(This is Part 5 of a seven-part series. See Part 1: Mortgage shopping: what you should know before you begin; Part 2: Pros and cons of fixed, adjustable mortgages; Part 3: Three options available on most mortgages; Part 4: How long should you take to pay off your mortgage? Part 6: Understanding choices in mortgage insurance and Part 7: Navigating real estate loan locks, docs.)

The down payment is the difference between the loan amount and the lower of sale price or appraised value. Many borrowers have no down payment decision to make because they have no money for one. Their challenge is qualifying for a loan without a down payment, for which they need excellent credit.

Borrowers with money to spare face an investment decision that is similar to the decision about whether to pay points. In both cases, you pay money now and receive a return in the future. It is a good investment if the return is high relative to other investment options.

However, you need more money to make an investment in a larger down payment that yields a high return. If you have surplus cash equal to 1 percent of the loan, you can earn a return of 20 percent or more by buying down the rate, provided you hold the mortgage for five years or longer. The same amount used to increase the down payment will only yield a return equal to the mortgage rate, or a little higher if you are also paying points, but well below the return on points.

To generate a higher yield from investment in a larger down payment, the investment must flip the loan into a lower mortgage insurance or interest rate category. These are generally 3 percent to 4.99 percent, 5 percent to 9.99 percent, 10 percent to 14.99 percent, and 15 percent to 19.99 percent.

For example, if a borrower taking a 6 percent mortgage at zero points with mortgage insurance considers raising the down payment from 5 percent to 7 percent, the loan will remain in the 5 percent to 9.99 percent mortgage insurance premium category. The premium will remain the same, and the return on investment will be limited to the interest saved on the reduction in loan amount, which is the rate of 6 percent.

If the borrower invests an additional 5 percent instead of 2 percent, however, the loan shifts into the 10 percent to 14.99 percent mortgage insurance premium category. Since the premium is lower, the return on investment rises to 11.6 percent (this and all other returns are calculated over five years using calculator 12a on my Web site).

Occasionally, a borrower’s desired down payment results in a loan amount slightly above the conforming loan limit — the maximum size mortgage that can be purchased by Fannie Mae and Freddie Mac ($359,650 in 2005). In such case, an increase in down payment that drops the loan amount below the maximum would also reduce the interest rate.

If the increase in down payment from 5 percent to 10 percent in the previous example not only reduced the mortgage insurance premium but also brought the loan amount below the conforming loan limit, the rate would drop from 6 percent to about 5.625 percent. In such case, the return on the investment in a larger down payment would rise from 11.6 percent to 17.9 percent.

In the sub-prime market, lenders adjust to smaller down payments with higher interest rates rather than higher mortgage insurance premiums. Further, the rate increments become larger as down payments become smaller. This means that an increase in down payment generates a higher rate of return the closer the initial down payment is to zero.

For example, a sub-prime lender’s price sheet covering 30-year FRMs on Sept. 9, 2005, showed rates of 6.8 percent and 7.05 percent for down payments of 15 percent and 20 percent, respectively. A borrower electing to increase the down payment from 15 percent to 20 percent in order to reduce the rate by 0.25 percent would earn a return on investment of 11 percent.

The same lender quoted rates of 7.9 percent with a down payment of 5 percent, and 8.55 percent with zero down. The borrower electing to raise the down payment from zero to 5 percent would receive a rate reduction of 0.65 percent and would earn a return on investment of 18.6 percent.

In summation, investment in a larger down payment earns a return on investment about equal to the mortgage rate unless it drops the loan amount into a lower mortgage insurance premium or interest rate category, or below the conforming loan limit. Usually, this requires a down payment increase of 5 percent of property value or more. In the sub-prime market, where borrowers pay for smaller down payments in the rate rather than in mortgage insurance premiums, the return on investment in a larger down payment is particularly high, especially when the down payment is low to start with.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

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