What Is the Best Use of Limited Cash?

July 17, 2006, Reviewed August 10, 2007

"I have been shopping on-line for a 30-year fixed-rate mortgage. All the sites ask you how much you want to put down, and all offer different combinations of interest rate and points. I have cash of only $15,000 to apply to either down payment or points on my $500,000 purchase, but obviously I can’t use it for both. Where do I get the biggest bang for my buck?"

Use Cash To Pay Points or For Down Payment?

Using your cash to pay points lowers the interest rate. (Points are upfront payments expressed as a percent of the loan). Using your cash for down payment reduces the amount you must borrow, and might or might not reduce the rate on the second mortgage if there is one, or reduce the mortgage insurance premium if there isn’t.

Which use of cash generates the lowest cost? There is no general answer to the question, every case is different. To answer the question in individual situations, Chuck Freedenberg and I developed a calculator that shows the total cost of any allocation of cash, over any time period specified by the user.

Finding the Optimal Allocation of Cash By Calculator

Cost includes upfront payments and monthly payments, plus the interest lost on those payments at the rate specified by the user. (This is sometimes called an "interest opportunity cost" because it refers to the return you could have earned on the cash used to make upfront or monthly payments.) Deducted from these costs are the tax savings at the user’s tax rate, and the reduction in the loan balances.

To use your case as an illustration, I shopped a 30-year fixed-rate mortgage on Amerisave, which is one of the sites that offer many rate/point combinations. I assumed you were purchasing a single-family home as your permanent residence, have good credit, can fully document your income and assets, are in the 27% tax bracket, and have an interest opportunity cost of 5%.

On the day I shopped, using your $15,000 for down payment would have resulted in a first mortgage of $400,000 at 7.375% and a second mortgage of $85,000 at 7.75%. If instead, the $15,000 had been used to pay points, the rate on the first mortgage would drop to 6.375%, and while the second mortgage rate would remain at 7.75%, the amount of the second would increase to $100,000.

The period you expect to have the mortgages is a critical factor. In general, the longer you have the mortgages, the stronger the case for paying points, since the savings from the lower interest rate accumulate month by month while repayment of the larger balance on the second mortgage is deferred.

I used the calculator to assess your deal over 2, 5 and 10 years. Over 2 years, paying points was a big loser. Over 5 years, however, paying points provided modest cost savings, and over 10 years the savings were very large.

I wondered whether the results would be the same for a borrower with $25,000 to use in the deal, who was otherwise the same? If this borrower used the $25,000 for down payment, he would pay 7.125% on the first mortgage of $400,000, and 7.25% on the second of $75,000. If he allocated the maximum amount to points, his rate on the first mortgage would drop to 6.125%, but his rate on the second (now for $95,000) would increase to 7.75%. Paying points would be a loser in this case over 2 years and over 5 years, with only moderate savings over 10 years.

The finding that the borrower with less cash does better allocating it to points than the borrower with more cash, seems to be counter-intuitive. The reason it works that way is that the borrower with less cash is already paying the maximum rate on the second mortgage, while paying points drops the rate on the first mortgage.

I strongly advise borrowers not to rely on any such generalizations, however, and to use the calculator to assess their own individual situation. It is number 14c on my web site, Best Allocation of Cash Between Points and Down Payment, and it accommodates mortgage insurance as well as piggyback second mortgages. Don’t allow yourself to be shoe-horned into a deal that may not be in your best interest without checking it out.
Rules of Thumb For Allocating Cash Between Down Payment and Points

"I'm allergic to calculators, do you have any old-fashioned rules-of-thumb that someone like me can use?"

Yes, here are the preliminary steps:

1. After you know the price of the house you are going to buy, you must estimate the cash needed for everything except down payment and lender fees. This includes third party settlement costs, including any transaction-based taxes, and tax and insurance escrows. You can find the data for this by shopping for a purchase mortgage on a web site that provides complete closing cost data, such as Eloan or Amerisave. Call this "required cash" or RC.

2. Subtract RC from the total cash (TC) you have available for the transaction to obtain the cash available for down payment and lender fees (AC). TC - RC = AC.

3. Divide AC by sale price (SP).

a. If AC/SP<3%, select a 100% loan and use all the cash to buy down the rate by paying points.

b. If 5%>AC/SP>3%, select a 97% loan and use any excess cash to buy down the rate.

c. If 10%>AC/SP>5%, select a 95% loan and use any excess to buy down the rate.

d. If 15%>AC/SP>10%, select a 90% loan and use any excess to buy down the rate.

e. If 20%>AC/SP>15%, select an 85% loan and uses any excess to buy down the rate.

f. If 25%>AC/SP>20%, select an 80% loan and use any excess to buy down the rate.

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