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Not everybody has the luxury to make a down payment of a home of more than 20%. But if you do, how do you decide just how big of a down payment to make? That’s the question we received recently from a reader named Kevin:

Here’s the email:

Hi Rob,

My wife and I are getting ready to purchase a new home and I have some questions about the financing. We will make at least a 20% down payment, but are in a debate about paying down extra money up front vs. keeping that money somewhat available to us in case of emergency. We have about another 50K to work with on top of the 20% down. We are trying to own as much of the house as we can and minimize the payment, while also conserving some cash as an emergency fund.

Hypothetical parameters:
Purchase Price: 300K
Term: 30 years
Interest: Assume 4.2%
Taxes and insurance: 6K per year

My question is this:
The options seem to be 1) pay extra money down to the bank, 2) pay points to reduce our interest rate and the cost of the loan, or 3) invest the additional down payment money above the 20%. I don’t understand much about option 2 or how to really evaluate the cost/benefit.

It also occurred to me that, for the loan described above, an additional 50K down would only reduce the payment by $244 per month. If I invest the 50K at 9% over 30 years, and withdraw $350 per month to pay toward the house, I end up with $95K at the end plus a reduced house payment. If I invest the 50K to earn 9%, but withdraw only $250 per month, I would end up with $278K.

I realize that this is not a Monte Carlo simulation, accounting for year to year swings, but the $250 per month scenario seems survivable in terms of giving us a monthly benefit today and preserving the money for emergencies, not running out, and even growing it.

What am I missing here? What would you do or recommend? Any advice or just some discussion would be great.

Best regards,

Kevin, let me start by saying that just the fact that you and your wife are considering such a question means that you are already on the right path. No matter which option you choose, you’re leaps and bounds ahead of the rest. Still, I do believe that one of these options is better than the others.

To recap, let’s look at the three options you’re considering:

  1. Pay extra money down to lower the amount of your loan
  2. Pay points to reduce the cost of the loan
  3. Invest the additional down payment money above the 20%

Option 1: Pay extra money down to the bank – a.k.a., Make a larger down payment

Here’s my initial thought: Once you put 20% down on a home, you have essentially eliminated the extra costs and risks associated with owning a home with minimum equity. A 20% down payment eliminates private mortgage insurance (PMI), higher interest rates due to risk pricing, and the possibility that a relatively minor decline in the market value of the property could put you “upside down” on the home (for example, even if the value of the house were to drop by 5% or 10%, you’d still have equity). The 20% down payment you’re proposing removes these risks, which improves the overall value of your investment.

However, there is a liquidity issue. Let’s say you decide to add your extra $50,000 to the down payment. That will drop the mortgage amount from $240,000 to $190,000. In doing so, your house payment falls from $1,674 per month ($1,174 principal and interest at 4.2%, plus $500 for taxes and insurance), down to $1,429. That will save you $245 per month. While the lower house payments may improve your monthly cash flow somewhat, it’s a drop in the bucket compared to having $50,000, available for any purpose, in a savings account.

This liquidity is more important than many homeowners understand. In the event that either Kevin or his wife lost their job, $50,000 in savings would be much more valuable than a monthly house payment that has been lowered by $245. Furthermore, it’s also important to remember that owning a home can be costly in terms of repairs, maintenance, and upgrades. Costs many people fail to consider include replacing the roof, repaving the driveway, replacing the furnace or air conditioning system, or even replacing windows or wood siding. Any one of those expenses will cost several thousand dollars, and a combination of two or more could easily run into the tens of thousands.

Still, there’s one more issue involved in making the largest down payment possible, and it is one that few homebuyers give much thought to – diversification. By putting all or most of your money into the down payment on a home, you are essentially putting most of your capital into a single investment. That will deny you the ability to diversify your money into non-housing assets.

That’s why I wouldn’t necessarily put more than 20% down on your home. While coming up with a 20% down payment has plenty of benefits, putting down more than that provides few returns.

Option 2: Pay points to reduce the cost of the loan

Kevin indicated in his email that he didn’t entirely understand this option. Therefore, I’m going to begin this section with a primer on what it means to pay points to reduce the cost of your loan.

A “point” is equal to 1% of the loan amount. In the case of a $240,000 mortgage, each point that Kevin and his wife will pay will be equal to $2,400.

Why pay the point(s)? Each point you pay will buy down the interest rate on your mortgage by about .125 in the case of a 30-year mortgage, or .250 for a 15-year mortgage.

Since Kevin and his wife are considering a 30-year loan, each point they pay upfront should reduce their mortgage interest rate by .125%.

Let’s imagine they are prepared to pay four points – $9,600 on a $240,000 loan – to permanently buy down the rate. That would result in a reduction in their interest rate of .50% (4 X .125) from 4.2% to 3.7%. That would also lower their monthly house payment from $1,674 to $1605 – a decrease of $69 per month. That doesn’t seem like a whole lot of savings, but over 30 years it will add up to $28,840. That’s about triple their $9,600 upfront “investment” in mortgage points.

Is that a good deal? Let’s look at the “recovery period” – how long it will take them to break even on the points paid upfront. This is a method commonly used to determine if a refinance is worth doing.

By dividing $9,600 in points paid by the $69 per month they’ll save on their payment, it will take Kevin and his wife 139 months before they break even. That’s a little more than 11.5 years.

There are two problems with this outcome:

The time value of money – If Kevin and his wife invest $9,600 at 9% instead of paying mortgage points, they will have accumulated over $127,000 at the end of 30 years. This is more than four times the $28,840 they will save on their house payment by buying points.

They may pay off the mortgage before 11.5 years – There is a better than even chance that Kevin and his wife will either sell their home and move or refinance the loan before hitting the 11.5 year mark. If they do either, they will have lost money as a result of paying the points upfront.

11.5 years is a long time to wait to get the benefit on an investment, and for that reason, paying points to reduce the cost of the loan is probably the least advisable option.

Option 3: Invest the additional down payment money above the 20%

Without reading any further, you can probably guess that this is the option I like best. By investing the money outside of your home, you will meet the diversification criteria that I addressed above. And by having the money invested in liquid assets, such as stocks, mutual funds, or exchange traded funds, you’ll also be addressing the liquidity issue. In Kevin’s case, he will be able to liquidate a portion of his investment portfolio in the event of a job loss or major expense or repair.

Further, having $50,000 invested outside the home simply provides Kevin and his wife with more options, come what may. And no matter what, the more options you have, the better.

With that being said, my suggestion to Kevin is that they avoid putting the entire $50,000 into equity investments. Some of it should be held in cash equivalents, so that there will always be some liquid funds available to meet whatever emergency may come up.

During my years in the mortgage industry, the vast majority of homebuyers “closed broke.” This was probably the biggest reason why so many people lost their homes to foreclosure during the financial meltdown. Kevin and his wife are on a completely different path, which means that they’ll be fine whatever option they choose.

Author Bio

Total Articles: 129
Since 2009, Kevin Mercadante has been sharing his journey from a washed-up mortgage loan officer emerging from the Financial Meltdown as a contract/self-employed “slash worker” – accountant/blogger/freelance blog writer – on OutofYourRut.com. He offers career strategies, from dealing with under-employment to transitioning into self-employment, and provides “Alt-retirement strategies” for the vast majority who won’t retire to the beach as millionaires.

Article comments

Ramona says:

It’s nice seeing people who are planning properly and asking such important questions. We know families who are almost broke because they just wanted to close on a house and never cared about such details. All kinds of commissions and fees did add up and they almost lost their homes.

Sue says:

Well, I would have a further question along these lines (loved this question and answers). I am a younger (63) widow who will soon be selling her house and moving to a different state. For the last few houses, cash was paid for the house, hence no mortgage. I have a decent guaranteed monthly income comprised of a very secure lifetime pension and social security. I also will have a substantial cash holding (around 150K) after I purchase the next house. I have no stock market/bond/equity holdings except of course as represented by my pension fund which is very well-managed (imagine that).

I will be investing a goodly sum of into the market into a sound managed mutual. But should I consider a partial mortgage and use more money for investments? Obviously, my lifeplace is very different than the folks you are advising here but I am wondering what you would advise for me??


Charlie says:

Hi, nice article, but not applicable in some parts of the country. Our local market is 100% cash, usually 30% over asking (strategy is to set it below a major price point and get competitive multiple bidding) and no contingency offers. Just sold ours like that with some crazy “adders” like free 30-60 day rent back and 2 DNA tests (from a Dr.). Lotsa cash flowing in from China & India (where our dollar has been flowing to support our cheap trinket habit).

Steve says:

Income tax re mortgage interest payments as deductions should be considered not only for Federal but State. Shortening the life of the loan (15 or 10 year) or the infamous hidden (13th monthly or 26 bi-weekly) would be another scenario to look at. Unless Kevin is adept at picking stocks, though the 9% annual is historically correct, a scenario of 7% or any other number should be taken into consideration. Finally, what are the odds of you staying in the house for 30 years?

I like the idea of investing the money, to help with having a good amount of reserves, and will provide some income if invested right. (Dividend stocks, ETF’s, and REITS) That 50K will most likely pay out 5% per year or about 200 per month. I would reinvest the money in the first 3 years, and then use half the income at that point to help pay down the mortgage. AT that point your funds are still invested and you will be reducing your risk with the mortgage.

Penny Price says:

If it were me, I would put the $50k towards the down payment. Reason being; you can expect the same monthly debt service throughout the life of your mortgage (refi unlikely as rates go up). Therefore, it may be helpful some years down the road to have the lower monthly obligation. You can always pay extra towards your mortgage if you have it, but I like the idea of keeping the monthly obligations down: keeps some pressure off of your family.

Diversification is important, to be certain, as is having a good 3 months of living expenses liquid, but it sounds like you will/do have some exposure to the stock market as it is.

Robert says:

An interesting question to ask would be whether to buy a house at all. Consider evaluating the scenario of buying versus renting a home in an average cost of living area within the US.

Diego says:

Here in Silicon Valley California in early 2017 a tiny house sells for a million dollars. Only a fool would risk more than the bare minimum to qualify for the loan. Case in point, sold old house for a million, why not buy new house for cash? This is the opposite of wealth building. The real estate market, like all markets forms bubbles, and is hard to predict in these “hot” areas. Meanwhile businesses and citizens continue to leave the state. I would never put more than the minimum down, at the lowest rate. Period. Just try taking some equity out of your home. It’s so much easier to walk to the bank and withdraw your own cash.