| Stretching Our Dollar: How Much Down Payment Is Enough? By Ejike Okpa II |
Real Estate Investment Analyst
Property Tax Consultant
Buying a home is probably one of the most single financial activity many will engage in during their life time. And considering that real estate constitute about 67% of the economic wealth of US, mortgage instruments becomes an integral part of the economy.
For us who came from a 'cash' economy, our understanding of financing and its utility in stretching one's resources is an issue. What I want to demonstrate through this medium is a limited analysis showing that putting down more than the required down payment does not reduce the life of the loan.
For illustration, let's consider a house on sale for $100,000, required down is 10% - $10,000, 7.25% interest and 30 year term, no balloon. This is a straight amortization - level payment.
With this background, the monthly payment is $613.96. If one gives additional payment, say $5,000, the monthly payment goes down to $579.85; a reduction of $34.11. However, if one retains the additional cash of $5,000 and sends in $34.11 towards reducing the mortgage principal balance, one will reduce the 360 month mortgage to 304 months, indicating about 4 years and 8 months reduction in the life of the loan. If the monthly payment is increased to $663.96, the life of the loan will be 284 months shaving 6 years and 4 months off the loan life.
You can also invest the $5,000 on your own and periodically apply the proceeds towards the mortgage balance reduction. Divide $5,000 by $34.11, and you will get 146.58 months. If this additional cash is invested and has a return of 15%, you can easily apply the earned income of $750 towards the loan and still retain the principal $5,000. The total value of the additional $34.11 or $50.00 paid monthly is $409.32 and $600 which is still less than the $750 return on $5,000. This simply the magic of financing and 'OPM' Other People's Money. And when ready to refinance, if you cannot reduce the interest by several basis point, save your money. The yardstick is to lower the existing interest by at least 0.5% before a refinance scenario makes sense.
And since most of us buy homes in our later years, any reduction in the life of the loan will be more beneficial. Also note that home appreciation is hardly more than 6% yearly and any appreciation is captured through capital gains when sold and is heavily taxed. This appreciation is considered an unearned income and is an IRS windfall. I need to qualify this by saying that investment analysis is specific to the investor and property. In some cases additional cash maybe required to cure a credit problem and or buy down the interest. But these can be negotiated without additional cash outlay.
Also note that home is a consumer product and there is no need to tie up liquid cash in its ownership. Instead, find some other investment vehicle to put the cash and periodically apply the proceeds to reduce the mortgage. Do not buy more home than you need because when you are ready to sale you may have a super adequate situation requiring cure and some reduction price.
I know sometimes most want to say they have the most expensive home in the neighborhood, avoid this situation because when the value of a house goes more than $500,000, its market gets limited and possible buyers are picky. Buy home that is functional to ones' need and do not build for your children as it may be obsolete when they are ready to own their own piece of America.
I welcome comments, reviews and questions. Watch out subsequent series on; How to Reduce Your Property Tax, Home Insurance Cost, How to Determine What Home to Buy, under this Stretching Our Dollar series. I am available for consulting but will offer community service analysis to our folks.
Okpa, principal of Integrated Valuation in Dallas, is a real estate investment analyst and property tax consultant. He is the Dallas bureau chief of The Black Business Journal, NigeriaCentral.com, and BBJonline.com.