Should You Make a Big Down Payment on Your Mortgage?

All homebuyers hear the same old advice: Get a low interest rate! Get a 15-year mortgage! Make a big down payment! Soon the house will be all yours!

Yeah, right. I’ll now explain how you can make a much better deal.

I will show how getting a higher interest rate, surprisingly, can enable you to pay LESS interest by the time you finish paying your mortgage.

I will also show that what matters most is not the interest rate. What really matters most is the actual interest paid.

Both of these strategies depend on one thing: what you do with your down payment.

The terms for mortgage loans vary by state. For my example, I’ll use the state of New York. Similar examples can be generated using the terms in other states. I choose New York because it’s a tough real estate market.

So here’s the basic example. Suppose you want to buy a property and are considering a mortgage loan of $600,000. Suppose that you also have $200,000 in hand that you might well include as a down payment. (You can lower both numbers if you’re in another state, but let’s just follow this numerical example, to make my points.)

Option 1:

Get a mortgage for $600,000, for 30 years, with a 3.5 interest rate, and a monthly mortgage payment of $2,694. Suppose also that your closing costs are $25,000 (e.g., one lender right now estimates $24,376 for a 3.6 interest rate).

The problem: after 30 years the total interest paid is $369,936.

Suppose now that instead you spend an extra $200,000 in the down payment, so that your loan is 400K instead. Then consider this scenario:

Option 2:

Get a mortgage for $400,000, for 30 years, with a 3.5 interest, and a monthly mortgage payment of $1,795. For this scenario, one lender estimates closing costs of: $16,801.

After 30 years, the total interest paid is $246,624. This is less than above, but still a lot.

Plus, maybe you might earn better interest in the stock market on the extra 200K that we’ve used in the down payment in Option 2.

Can you spend even less on the total interest paid?

YES. Consider what happens if you get a higher interest rate.

Option 3.

Get a mortgage for $600,000, for 30 years, with a 4.5 interest, and a monthly mortgage payment of $3,040.

The problem: after 30 years, the total interest paid would be: $494,437 — higher than options 1 & 2.

However, since this is an uglier interest rate, the mortgage lenders give you an incentive to take it. For example, they may give you a “discount” of about $20,000 on the loan origination fee (closing costs).

Also, they don’t necessarily know that you have $200K more to use. So, after buying your property, one month later you make a one-time payment of $200,000, this creates a new option.

Option 4.

Get a mortgage of $600,000, for 30 years, with a 4.5 interest, and a monthly mortgage payment of $3,040. Here your closing costs will be much lower, say: $5,098. This is $20,000 lower than in Option 1! And now, make a one-time payment of $200,000 in Month 2.

The loan will now end not in 30 years, but in about 16 years. The monthly payment remains $3,040 throughout. But, instead of paying mostly interest each month for years, now starting in Month 3 you will pay 50/50 on the principal and interest! And that’s really great.

For example, your Month 1 payment (the very first monthly payment on your loan) is $2,250 interest plus $790 payment on principal. Most of your money is being wasted, lost, on paying interests.

But your Month 3 payment is $1,494 interest plus $1,546 principal! This monthly interest payment is LOWER than in any of the options above.

And here’s the BIG PAYOFF. At the end of the loan, in 16 years, you have paid $600,000 in principal, as always—but only $155,294 in interests!

Compared to Option 1 (“the lower interest rate of 3.5”) you’ve saved $214,642, plus, about $20,000 in closing costs by getting the interest rate of 4.5!

In other words, the lending bank lost $224,642. This is not a matter of opinion—they wasted $20,000 and they did not earn $214,642 that they expected to get from you.

That’s my advice. Don’t just win against the seller, when buying a property. Win against the mortgage lender.

This demonstrates the first claim that I made at the start: that getting a higher interest rate, surprisingly, can enable you to pay LESS interest by the time you finish paying your mortgage.

Compare now Option 4 with Option 2. Option 4 saves you $11,700 in closing costs. It also saves you $91,330 in interests!

Now let me further illustrate my second claim: What matters most is not the interest rate—it’s the actual interest paid.

You can try Option 4 with a 3.5 rate. However, if so, then you won’t get the $20,000 upfront discounts for “the higher” interest rate. With 3.5 the 30-year interest payments will be $126,979, which seems better than $155,294. But not necessarily, once you take into account the extra $20,000 (in 2016 dollars).

For example, by plunking that $20K as a prepayment along with the one-time $200K payment (making a $220K prepayment), into the 4.5 interest loan, your final paid interests, at the end of the loan, becomes: $136,817.

So, Option 5, THE WINNER:

Get a mortgage for $600,000, for 30 years, with a 3.5 interest rate, and a monthly mortgage payment of $2,694. The closing costs might be $25,000. Then prepay $200,000 in Month 2 of the loan schedule.

The loan will therefore end in the 17th year, and the total interests paid will be merely $126,979, far better than Options 1, 2, 3, but roundabout as good or better than option 4.

In Option 1, the total interest paid was about $243,000 more. Can you beat Option 5’s instant savings of about $243K by putting your initial 200K in the stock market, and waiting 16 years? Maybe, but I doubt it. Yes, if they guaranteed, say, 5% compound interest rate, but they don’t.

For example, in Option 5, you keep your $200,000, inasmuch as it’s in the value of your home. Plus, you save $243,000 in interests. That’s $443,000 in assets that you keep in just two months! In seventeen years your mortgage is paid off. Since you save $243,000 in interests (over 30 years), let’s suppose you invest it in the stock market each month in equal installments of $675 ($675 x 12 months x 30 years = $243K) and earn an annual 4% compound interest rate. So, after 30 years, you still own your house, and your $243K has become $469,605.

In Option 1, however, you try to keep the $200,000 by investing it. Suppose you earn an annual 4% compound interest rate. After 30 years you’d have $660,077. Subtract the surplus of interests you pay over those 30 years: $243,000 more than in Option 5. Thus, the apparent $660K becomes $417,077.

Option 5 is better. And you can also lose big in the stock market, with Option 1. You might lose 50%.

Summing up, I’d gladly take the instant savings of $243,000 from Option 5.

I hope this information has been helpful. Beware of falling for the old mortgage lenders’ clichés—they just want your money.