How Much Should I Put Down?

March 7, 2005, Revised September 4, 2007, November 22, 2011

In answering the question of how much to put down, it is useful to categorize borrowers into three groups, based on how much it is possible for them to put down.

The Down Payment Decision: Borrower Can Put Nothing Down

Borrowers who have no money for a down payment, have no down payment decision to make. Their problem is qualifying for a loan without a down payment. Before the financial crisis in 2007-8, no-down payment loans were available for borrowers with excellent credit who were able to fully document their income. After the crisis, no-down payment loans were available only to veterans under the VA program, and to low-income borrowers purchasing homes in rural areas under the USDA program.

The Down Payment Decision: Borrower Can Put Less than 20% Down

The second group consists of those who can make a down payment of less than 20%. They must decide whether to put down the most they can afford, or something less – 5%, say, when they can afford 10%? See The Pros and Cons of Making a Larger Down Payment.

Those in the second group must then decide whether to take a larger first mortgage, say 90% of value, and pay for mortgage insurance; or take an 80% first mortgage plus a second ("piggyback") mortgage at a higher rate for the additional amount needed. See Can Two Mortgages Cost Less than One? Only the first option survived the financial crisis.

The Down Payment Decision: Borrower Can Put More Than 20% Down

The third group consists of those who can afford to put more than 20% down, perhaps even 100%, and must decide how much it should be? They are the major subject of this article.

Assume Jacques has $100,000 of surplus cash, over and above the 20% he will put down. He can use the $100,000 either to make a larger down payment, or he can continue to hold it as an investment. His objective is to have the most wealth at the end of the period during which he expects to be in the house; or, if his wealth is the same at that point, he wants to select the option that will allow him to spend more over the period.

There is one simple rule that, if followed, will achieve this objective. Take the mortgage if the investment return on the $100,000 is higher than the mortgage rate. If the investment return is lower than the mortgage rate, use the $100,000 as an additional down payment.

This is an application of the standard investment rule, that the better investment is the one providing the higher return. Increasing the down payment is an investment in the mortgage you avoid, on which the yield is the mortgage rate you don't pay. For example, if you put $100,000 down instead of borrowing that amount at 6%, your return on the $100,000 is the 6% you would have paid on the mortgage. If the alternative use of the $100,000 is to keep it in the bank earning 3%, you do better using it to make a larger down payment.

Here is a simple example that will illustrate the principle. If Jacques earns 3% on his $100,000 of financial assets, his investment income is $250 a month. If the 6% mortgage he is considering is interest-only, it will cost him $500 a month. Net, he loses $250 a month.

If, instead, he uses the $100,000 to increase his down payment, he has no investment income or mortgage interest to pay, so his income from these sources is zero. He thus has $250 a month in disposable income that he would not have had he taken the mortgage. He can live a richer life by spending it, or he can invest it and end up with more wealth, or some combination of the two.

Older Borrowers May Opt For Mortgage Avoidance More Than Younger Borrowers

An investment in mortgage avoidance makes good sense for elderly home buyers whose money is invested very conservatively. Their objective is more likely to be maintaining consumption rather than increasing wealth. So long as the mortgage rate exceeds the yield on their investments, consumption at a given level will deplete their wealth less rapidly if they avoid a mortgage.

Home buyer with excess cash who can earn a return above the mortgage rate may do better taking the mortgage. It may pay to take a mortgage at 6% if you can invest at 10%. I say "may" rather than "will" because any investments that promise yields above the mortgage rate carry risk, whereas the return on mortgage avoidance has no risk.

Younger buyers with excess cash are in the best position to assume the risks. If they take the mortgage and invest their cash in a diversified portfolio of common stock, they have an excellent chance of earning 9-10% over a long period. Because they are young, they can take a long view and ride out short-term fluctuations in the stock market. See Borrow on Your Mortgage to Invest in Common Stock?

But they should have the stomach for it. If they are going to have a gastric upset every time the value of their portfolio drops, they should opt for the safe return on investment in mortgage avoidance.

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