At any given time, there are dozens of basic mortgage formats from which individual borrowers can choose, yet before one can look at specific financing plans two important issues must be considered:
First, is it better to have a large down payment or a smaller one?
Second, is a short-term loan more attractive than a stretched-out mortgage with smaller monthly payments?
The real issue raised by the first question concerns the worth of alternative investments and such future income as a borrower may expect. Here are several ways to look at the subject.
Case No. 1. The cost of mortgage financing is 12 percent, while consumer credit charges range from 18 to 21 percent. For buyers at the beginning of their income-producing years, a small down payment generally makes the most sense. The reason is that such individuals are at a point where they are first acquiring major personal goods such as furniture or a new car. In effect, cash invested in consumer goods earns more (18 percent in this illustration) than the same amount applied to the purchase of a home.
Case No. 2. The cost of financing is 12 percent, and commercial credit fees range from 18 to 21 percent. In this example, the borrowers are in their mid-30s, have acquired basic personal goods, have solid, on-going incomes and are entering their peak earning years. Because consumer purchases are likely to represent a smaller proportion of disposal income than would be the case with entry-level workers, the choice here also favors a low down payment. Putting less into a mortgage in this situation makes more money available for consumer goods, thereby eliminating high credit costs. At the same time, a higher mortgage balance will create a substantial, but not unreasonable, yearly interest expense, which offers certain tax advantages.
Case No. 3. The cost of mortgage financing is 18 percent. At this level, buying decisions often are postponed or cancelled because the cost of funds is so high. If property is to be purchased at all, a large down payment should be considered because few other investments are likely to offer an equal level of return. Two other points also should be noted. Buyers with capital during times when interest rates are high have considerable bargaining power because they are likely to be the beneficiaries of a buyer's market, a period when many sellers are anxious to market their properties but few purchasers have the resources or inclination to buy. Also, by putting down a substantial portion of the purchase price in cash, buyers will qualify more easily for whatever financing may be available.
Case No. 4. The cost of financing is 10 percent, and other investments such as stock and bond purchases will provide higher yields. Here a small down payment is dictated because other investments can be used to subsidize housing costs.
Case No. 5. A buyer has just retired, sold a large home and, in turn, bought a small condominium. In such situations, retirees are likely to see their incomes drop as high salaries are replaced by Social Security and pension payments. In this case, it makes sense to use the proceeds from the sale of the first house to acquire the second property, thus liminating mortgage payments at a time when cash flow may be reduced siginificantly.
It should be said that approaches to the down-payment issue also may differ as a result of intent. The purchase of a residence includes personal preferences that may not be dollar-sensitive. Investment purchases, however, are by definition tied to bottom-line statistics such as revenue, cash flow and tax considerations. Most investors opt for the smallest possible down payment and the use of "other people's money" (OPM) so theirs can be conserved and used elsewhere.
The second issue concers stretched-out mortgages: Can they be advantageous to borrowers? To answer this one must look at the numbers.
Suppose a buyer borrows $100,000 at 13 percent. A 30-year note for this sum will require monthly payments of $1,106, while a 40-year loan will have monthly installments of $1,089.
However, for the monthly saving of $16.50, a figure which is positively minute in the context of this loan, the 40-year note will require 120 additional monthly payments. If paid out over their respective terms, the ultimate difference between the two loans will be $124,735 ($1,106.199 x 360 payments vs. $1,089.514 x 480 payments).
Thus, by making the 360 monthly payments of $16.50, or $5,940 over 30 years, a borrower potentially could save more than the entire value of the original loan.
Stretched loans limit monthly principal reductions. This effect, plus marginal monthly savings, suggest that longer loans are not generally favorable to buyers. If, for example, in the context of a $100,000 mortgage, a monthly saving of $16.50 is economically important, both the buyer and the lender would be better off if the purchaser bought a smaller, more affordable property. NEXT WEEK: Buying homes at discount through proper financing