How should we think about how large of a downpayment to make?
February 27, 2024 8:11 AM Subscribe
My partner and I are currently searching for our first home in a city on the US East Coast, focusing on houses priced around $1 million. We have about $250k saved in cash for the down payment and closing costs, and an additional $250k in non-retirement stock investments that we could potentially sell (paying 15% capital gains) to increase our down payment size or buy points. This would reduce our future monthly mortgage payment at the cost of having more of our total net worth tied up in our house. Should we do this? If so, how much of the stock should we sell?
If this were a couple of years ago, I think the conventional wisdom would have been: sell what ever you need to make a 20% down payment to avoid PMI, and then keep the rest of the assets in other more liquid equities to avoid paying taxes on realized gains, increase your optionality (can always sell stocks to pay down the mortgage later), and because it felt like a pretty safe bet that the stock market would earn more than 3% nominally over medium time frames. Perhaps this is still the right answer, but it feels less obviously true with morgatage interest rates hovering around 7%.
Coming up with the optimal allocation now seems to depend on the following factors:
- Do we believe our stock portfolio will generate over 7% nominally over the lifetime of the mortgage?
- Are there are specific mortgage-size thresholds below which we can get a step-change improvement in interest rates? (From playing around with a few calculators, it seems like making a larger down payment might push us from a non-conforming to a conforming mortgage, resulting in about a half of a percentage point improvement in our interest rate.)
- How likely do we think one or more of us is to experience a job loss? (Having a larger mortgage means a higher monthly payment. But it also means we have significantly more liquid resources to make mortgage payments if need be if our income streams dry up for a while.)
- Ease/difficulty and fees associated with paying off a mortgage early/recasting if we want to change this allocation later?
If you have faced this decision recently, I would love to hear what arguments pushed you in either direction and if there were any resources, simple spreadsheet models, or formulas that helped you decide. Or if there are factors we should be thinking about that I have not listed above. Thanks!
If this were a couple of years ago, I think the conventional wisdom would have been: sell what ever you need to make a 20% down payment to avoid PMI, and then keep the rest of the assets in other more liquid equities to avoid paying taxes on realized gains, increase your optionality (can always sell stocks to pay down the mortgage later), and because it felt like a pretty safe bet that the stock market would earn more than 3% nominally over medium time frames. Perhaps this is still the right answer, but it feels less obviously true with morgatage interest rates hovering around 7%.
Coming up with the optimal allocation now seems to depend on the following factors:
- Do we believe our stock portfolio will generate over 7% nominally over the lifetime of the mortgage?
- Are there are specific mortgage-size thresholds below which we can get a step-change improvement in interest rates? (From playing around with a few calculators, it seems like making a larger down payment might push us from a non-conforming to a conforming mortgage, resulting in about a half of a percentage point improvement in our interest rate.)
- How likely do we think one or more of us is to experience a job loss? (Having a larger mortgage means a higher monthly payment. But it also means we have significantly more liquid resources to make mortgage payments if need be if our income streams dry up for a while.)
- Ease/difficulty and fees associated with paying off a mortgage early/recasting if we want to change this allocation later?
If you have faced this decision recently, I would love to hear what arguments pushed you in either direction and if there were any resources, simple spreadsheet models, or formulas that helped you decide. Or if there are factors we should be thinking about that I have not listed above. Thanks!
I think you're underestimating how much free cash you should keep on hand, like you predict in your third bullet point.
New homes always need some huge amount of startup cash once you close. Whether it's furniture, landscaping, repairs to everything your home inspector missed... you're going to need to be somewhat liquid.
I'd get a relationship started with a mortgage broker, who can advise on thresholds and rates and will be monitoring the market for you when it's a possible good window to refinance. Recasting is great but that's totally up to the servicing bank, which you will not be able to choose in most cases. Mortgages get moved and sold all the time.
posted by JoeZydeco at 8:24 AM on February 27 [3 favorites]
New homes always need some huge amount of startup cash once you close. Whether it's furniture, landscaping, repairs to everything your home inspector missed... you're going to need to be somewhat liquid.
I'd get a relationship started with a mortgage broker, who can advise on thresholds and rates and will be monitoring the market for you when it's a possible good window to refinance. Recasting is great but that's totally up to the servicing bank, which you will not be able to choose in most cases. Mortgages get moved and sold all the time.
posted by JoeZydeco at 8:24 AM on February 27 [3 favorites]
Do we believe our stock portfolio will generate over 7% nominally over the lifetime of the mortgage?Depends on the exact composition of your portfolio, but the answer is probably yes (unless you think the next 30 years are going to be different from most of the previous 30 year periods).
Are there are specific mortgage-size thresholds below which we can get a step-change improvement in interest rates?My understanding is the only one of these is at the boundary between conforming and jumbo. The rate difference is usually pretty small. Above $750,000 the effective cost is a little higher than comparing the conforming and jumbo rates would suggest, because you can no longer deduct 100% of your annual mortgage interest on your tax return. The difference this makes at your price point will be very small, but it might be worth running the numbers.
How likely do we think one or more of us is to experience a job loss?This isn't the only reason it's good to have a liquid nest egg (even beyond the several months of mortgage payments your lender will likely insist you have saved up). You may run into health issues. You may want or need to take an expensive trip or start a business. The roof on your new house may need replacing.
Ease/difficulty and fees associated with paying off a mortgage early/recasting if we want to change this allocation later?This varies by lender and loan, so you will of course need to discuss this with the lender. If it were me, I would put 20% down, I wouldn't dream of making early payments at the current rates, and I'd worry more about the likelihood that I would want to refinance in a year or two at a lower rate (a good problem, so "worry" is the wrong word).
posted by caek at 8:25 AM on February 27 [1 favorite]
It seems that either one or two of you have relatively high incomes, which is obviously good for carrying a sizable mortgage. I would advise on keeping a lot of liquidity in cash like instruments or in stock that you can use if necessary. My wife and I are both in tech related fields, where compensation is good but layoffs do happen. We've been able to ride out these things so far because of savings/ other assets, but it is certainly stressful. Also, things like staying home with children, childcare, etc. can complicate things greatly.
My advice is to keep hold of a much of you money as feasible. If you generate excess cashflow then pay down the mortgage aggressively if the interest rates remain high. Your net worth is the same whether you have a $1M house with a $500k mortgage or $1M house with $750k mortgage and $250k in stock/ cash. However, the latter affords for much better sleep.
posted by zeikka at 8:26 AM on February 27 [3 favorites]
My advice is to keep hold of a much of you money as feasible. If you generate excess cashflow then pay down the mortgage aggressively if the interest rates remain high. Your net worth is the same whether you have a $1M house with a $500k mortgage or $1M house with $750k mortgage and $250k in stock/ cash. However, the latter affords for much better sleep.
posted by zeikka at 8:26 AM on February 27 [3 favorites]
It really depends on your interest rate. That's the answer. That was the answer when rates were 3% too.
Thought experiment: Rule of 72 is how long an interest rate takes to double. You divide your rate by 72, so 3 divided by 72 is 24 years - so in a 30 year mortgage at 3% you will pay a bit more than 1X the amount of interest. 7/72 = 10 years. So you will pay 3X the amount of interest at 7% over 30 years.
Can the stock market beat that over 30 years? Probably, but over a shorter time period? That's more questionable.
Do you have any options of buying down your rate? That would be more cost effective than paying more down payment, as selling stock also has costs. Let's buy down 7 to 6% - 12= a bit more than 2X. 5%: 2X over 30 years. 250,000 * .15 = $37500 in taxes, so you have to compare that to your interest paid. Taking out only the amount you invested (ie: you pay no taxes) would be the amount I would take out.
posted by The_Vegetables at 8:26 AM on February 27
Thought experiment: Rule of 72 is how long an interest rate takes to double. You divide your rate by 72, so 3 divided by 72 is 24 years - so in a 30 year mortgage at 3% you will pay a bit more than 1X the amount of interest. 7/72 = 10 years. So you will pay 3X the amount of interest at 7% over 30 years.
Can the stock market beat that over 30 years? Probably, but over a shorter time period? That's more questionable.
Do you have any options of buying down your rate? That would be more cost effective than paying more down payment, as selling stock also has costs. Let's buy down 7 to 6% - 12= a bit more than 2X. 5%: 2X over 30 years. 250,000 * .15 = $37500 in taxes, so you have to compare that to your interest paid. Taking out only the amount you invested (ie: you pay no taxes) would be the amount I would take out.
posted by The_Vegetables at 8:26 AM on February 27
Also came here to say you should talk to an independent mortgage person and a tax expert. Independent mortgage professionals have so many options that aren't obvious to anyone who doesn't work in the business, and they're set up to compare everything and make recommendations. Even if you think you have the best bank in the world, an independent mortgage professional may find you something better than your bank offers. Mortgage interest deduction limits changed a few years ago, too, so the implications of carrying a jumbo mortgage or buying points now are different than they used to be, and a tax expert can help you make informed choices. Offhand I wouldn't want to pay capital gains taxes just to buy points because I think you're losing money both ways there, but I'm definitely not a tax expert and I think you should ask one those questions instead of going off my hunches.
posted by fedward at 8:35 AM on February 27 [2 favorites]
posted by fedward at 8:35 AM on February 27 [2 favorites]
You're more knowledgeable and more thoughtful than 99 percent of homebuyers. Two additional thoughts:
1) How much you want to keep in non-retirement stocks depends also on your exposure in retirement accounts. If you have a substantial portion of your investments in stocks in retirement accounts, that should push you to selling more of your stocks for a larger down payment, and vice versa.
2) Don't worry too much about the optimal down payment. For example, on a $800,000 mortgage, getting the rate down by 1/2 a point means $4,000 a year in savings. But selling another $50,000 in stocks and putting it into the downpayment, and then finding out that you could have made a 1% higher (or lower) return costs you (or gains you) only $500 a year - and you can't predict that in advance.
posted by Mr.Know-it-some at 8:41 AM on February 27 [2 favorites]
1) How much you want to keep in non-retirement stocks depends also on your exposure in retirement accounts. If you have a substantial portion of your investments in stocks in retirement accounts, that should push you to selling more of your stocks for a larger down payment, and vice versa.
2) Don't worry too much about the optimal down payment. For example, on a $800,000 mortgage, getting the rate down by 1/2 a point means $4,000 a year in savings. But selling another $50,000 in stocks and putting it into the downpayment, and then finding out that you could have made a 1% higher (or lower) return costs you (or gains you) only $500 a year - and you can't predict that in advance.
posted by Mr.Know-it-some at 8:41 AM on February 27 [2 favorites]
I want to stress that it's OK to have a value function that includes less tangible things. I have a PhD in math, I know how crunching the numbers works. But this isn't just some optimization problem on a ledger sheet, it's your life. There's known unknowns (how does the market perform, what happens to interest rates) and unknown unknowns, and those are potentially huge*. I think you would do well to consider things like your risk aversion and comfort zone, how you feel about the house, how you imagine the next few decades of your life etc. E.g: do you think you'd be happy to live there until you die? Do you have any uncertainty in your employment in the next 10 years? I also really like having a smaller mortgage payment, in a way that defies naïve accounting logic.
TLDR: I put down a decently larger payment than 20% and habitually pay more than my minimum payment. I have been very happy with this decision, especially when *I stopped working due to covid/childcare issues (which I never would have predicted as a likely situation), ymmv.
posted by SaltySalticid at 8:50 AM on February 27 [8 favorites]
TLDR: I put down a decently larger payment than 20% and habitually pay more than my minimum payment. I have been very happy with this decision, especially when *I stopped working due to covid/childcare issues (which I never would have predicted as a likely situation), ymmv.
posted by SaltySalticid at 8:50 AM on February 27 [8 favorites]
how you feel about the house, how you imagine the next few decades of your life etc. E.g: do you think you'd be happy to live there until you die? Do you have any uncertainty in your employment in the next 10 years?
The more expensive the house is, the less people sell. The average person who purchases a home that is around $1m has lived there 20 years, vs $250k homes and below at 7 years.
posted by The_Vegetables at 8:59 AM on February 27
The more expensive the house is, the less people sell. The average person who purchases a home that is around $1m has lived there 20 years, vs $250k homes and below at 7 years.
posted by The_Vegetables at 8:59 AM on February 27
Also came here to say you should talk to an independent mortgage person and a tax expert.
Yes, this. Also, don't overlook that mortgage interest rates will come down. No one can predict how quickly that will happen but it will happen and you will be able to refinance. A good independent mortgage person can help you model out how that eventuality might affect the decisions you make today about the structure of your mortgage.
posted by John Borrowman at 9:26 AM on February 27
Yes, this. Also, don't overlook that mortgage interest rates will come down. No one can predict how quickly that will happen but it will happen and you will be able to refinance. A good independent mortgage person can help you model out how that eventuality might affect the decisions you make today about the structure of your mortgage.
posted by John Borrowman at 9:26 AM on February 27
1) How much you want to keep in non-retirement stocks depends also on your exposure in retirement accounts. If you have a substantial portion of your investments in stocks in retirement accounts, that should push you to selling more of your stocks for a larger down payment, and vice versa.
I was going to make a similar point. In addition to looking at what is financially optimal for this transaction, plus the non-financial components, you need to look at how this fits into your larger financial picture.
For example, it's one thing to consider liquidating $250k of stocks when you also have $2 million in your retirement accounts, but a very different thing if the $250k represents most of your total savings. Personally I'd be uncomfortable having my net worth be mostly or entirely house equity, but other people are completely comfortable with that.
posted by Dip Flash at 9:41 AM on February 27
I was going to make a similar point. In addition to looking at what is financially optimal for this transaction, plus the non-financial components, you need to look at how this fits into your larger financial picture.
For example, it's one thing to consider liquidating $250k of stocks when you also have $2 million in your retirement accounts, but a very different thing if the $250k represents most of your total savings. Personally I'd be uncomfortable having my net worth be mostly or entirely house equity, but other people are completely comfortable with that.
posted by Dip Flash at 9:41 AM on February 27
One thing to add: people sometimes present putting additional money down, or making early payments, as a thing they recommend because they are risk averse, or because they value security in a way that cannot be accounted for by a simple calculation.
I want to gently push back on this, or at least point out that there is another way to think about it. Putting more money down, or making early payments, can itself be risky. By doing this you are tying up liquid savings in an illiquid asset that is also your home. You're losing flexibility. If you overdo it, then you may not have enough cash on hand to respond to bad luck or an opportunity. You might be forced to sell your home or take on a new loan at rates you wouldn't otherwise choose (maybe you lose your job when mortgage rates are 10%), while the version of you that put 20% down and made no early payments simply tapped into their savings.
The details depend strongly on how big your savings and expenses are, so there's no way a stranger on the internet can tell you truthfully that it's less risky to pay a loan off quickly, or that it's less risky to pay a loan off as slowly as possible. My point is that you can make the usual intangible non-quantitative risk/security argument for paying off a loan as quickly as possible work in the opposite direction too.
(This is in addition to the point Dip Flash just made, i.e. putting all your net worth in a single house makes you very vulnerable to the local housing market. It's a big bet on a single asset. It's typically a good bet with lots of upside, but it's difficult to say it's a cautious bet relative to more diversified alternatives.)
posted by caek at 10:26 AM on February 27 [3 favorites]
I want to gently push back on this, or at least point out that there is another way to think about it. Putting more money down, or making early payments, can itself be risky. By doing this you are tying up liquid savings in an illiquid asset that is also your home. You're losing flexibility. If you overdo it, then you may not have enough cash on hand to respond to bad luck or an opportunity. You might be forced to sell your home or take on a new loan at rates you wouldn't otherwise choose (maybe you lose your job when mortgage rates are 10%), while the version of you that put 20% down and made no early payments simply tapped into their savings.
The details depend strongly on how big your savings and expenses are, so there's no way a stranger on the internet can tell you truthfully that it's less risky to pay a loan off quickly, or that it's less risky to pay a loan off as slowly as possible. My point is that you can make the usual intangible non-quantitative risk/security argument for paying off a loan as quickly as possible work in the opposite direction too.
(This is in addition to the point Dip Flash just made, i.e. putting all your net worth in a single house makes you very vulnerable to the local housing market. It's a big bet on a single asset. It's typically a good bet with lots of upside, but it's difficult to say it's a cautious bet relative to more diversified alternatives.)
posted by caek at 10:26 AM on February 27 [3 favorites]
Closed on a home on the west coast 5 weeks ago. Closing costs ended up about 3.5% of purchase price. CA is a particularly bad home insurance market but I also wish I had started asking for quotes the second I was thinking about offering on a house.
Interest rate was 7%. Bought down points to 6.5% with a breakeven of about 2 years (I regret doing this, I didn't properly research it).
Similar to you, I was debating putting in an extra $200k in down payment. Ultimately I hedged and went with the middle option of $100k extra. I've mentally bucketed $100k for unexpected costs and have about 2 years in my emergency fund without dipping into retirement accounts.
Pros to bigger down payment:
- Future stock market earnings are unknown and 8% (7% *1.15 capital gains) seems tough to beat.
- If interest rates drop a lot in the future, I could refinance and pull out more money (though this is expensive to do)
- Mentally easier to deal with a lower payment and a lower loan
- Mortgage interest deduction is less helpful with the higher standard deduction and the $750k loan cap.
Pros to smaller down payment:
- Extra year of survival if I lose my job
- Counting on interest rate drop by end of 2024, can refinance then
- If the house appreciates at a greater rate than the interest rate and you plan to sell in the future, then it makes sense to borrow as much money as you can. This was an easier decision when rates were < 4%. In the SF Bay Area, average appreciation the last decade was approx. 8% but that includes the covid jump in prices.
- Stock market is currently going strong.
posted by just.good.enough at 11:13 AM on February 27 [1 favorite]
Interest rate was 7%. Bought down points to 6.5% with a breakeven of about 2 years (I regret doing this, I didn't properly research it).
Similar to you, I was debating putting in an extra $200k in down payment. Ultimately I hedged and went with the middle option of $100k extra. I've mentally bucketed $100k for unexpected costs and have about 2 years in my emergency fund without dipping into retirement accounts.
Pros to bigger down payment:
- Future stock market earnings are unknown and 8% (7% *1.15 capital gains) seems tough to beat.
- If interest rates drop a lot in the future, I could refinance and pull out more money (though this is expensive to do)
- Mentally easier to deal with a lower payment and a lower loan
- Mortgage interest deduction is less helpful with the higher standard deduction and the $750k loan cap.
Pros to smaller down payment:
- Extra year of survival if I lose my job
- Counting on interest rate drop by end of 2024, can refinance then
- If the house appreciates at a greater rate than the interest rate and you plan to sell in the future, then it makes sense to borrow as much money as you can. This was an easier decision when rates were < 4%. In the SF Bay Area, average appreciation the last decade was approx. 8% but that includes the covid jump in prices.
- Stock market is currently going strong.
posted by just.good.enough at 11:13 AM on February 27 [1 favorite]
If we assume that investment gains and your mortgage interest rate are the same (which, 7% is a bit conservative for historic stock market gains) then you want to be modeling taxes as your largest variable. Ask an accountant!
Quick research suggests that the mortgage interest deduction is capped at $750,000. You'll be deducting your interest at a rate that's likely much higher than the 15% which is (likely, eventually) the rate you're paying on investment gains.
Here's a simplified illustration (with round numbers to help my tired brain)
I invest $100 and it appreciates by 10% in a year. That's a $10 gain, on which I have to pay $1.50 in federal taxes (assuming I hold it long enough for long-term 15% tax rates). So my net is $8.50.
Instead, I spend $100 to pay down my mortgage at 10%. After a year, I've saved $10 in interest. I also get to deduct $10 less on my taxes. I pay roughly 25% in federal taxes, so I've reduced my tax deduction by $2.50. Net benefit from my $100 is $7.50. Should've invested instead!
If I were you, I would aim for an initial principle of $750k because that's your sweet spot for tax deduction, PMI, and favorable interest rates. I'd also try to minimize points or additional closing fees even it means a slightly higher interest rate in order avoid liquidating stock. THAT is because I have never held a mortgage for more than 3-4 years without either moving or refinancing, and as soon as you do that your points are just wasted money.
If you imagine a future in which the stock market starts to produce consistently worse-than-7% gains, then you are probably also imagining a future in which interest rates have dropped, so you're no longer stuck paying 7% in that scenario anyway. Having slightly over 20% equity in the house allows you to refinance without having to kick in extra cash, even if the housing market slumps a bit. The BIGGEST mistake you can make in this whole decision is failing to refinance when rates are lower.
Disclaimers/personal baggage:
1) I bought my first house in 1998, and interest rates have trended downwards ever since. This accounts for my assumption that no one loan will last more than a few years -- I've only owned 3 houses but have had 10 or so different mortgages.
2) I live in constant fear of the wolf at the door, and always keep a couple of year's salary available as a hedge against disability or other forms of unemployability. So I can't really imagine cashing in your $250k which I would need as a security blanket.
3) I'm not a tax or mortgage professional, just a compulsive optimizer.
posted by eraserbones at 12:36 PM on February 27 [2 favorites]
Quick research suggests that the mortgage interest deduction is capped at $750,000. You'll be deducting your interest at a rate that's likely much higher than the 15% which is (likely, eventually) the rate you're paying on investment gains.
Here's a simplified illustration (with round numbers to help my tired brain)
I invest $100 and it appreciates by 10% in a year. That's a $10 gain, on which I have to pay $1.50 in federal taxes (assuming I hold it long enough for long-term 15% tax rates). So my net is $8.50.
Instead, I spend $100 to pay down my mortgage at 10%. After a year, I've saved $10 in interest. I also get to deduct $10 less on my taxes. I pay roughly 25% in federal taxes, so I've reduced my tax deduction by $2.50. Net benefit from my $100 is $7.50. Should've invested instead!
If I were you, I would aim for an initial principle of $750k because that's your sweet spot for tax deduction, PMI, and favorable interest rates. I'd also try to minimize points or additional closing fees even it means a slightly higher interest rate in order avoid liquidating stock. THAT is because I have never held a mortgage for more than 3-4 years without either moving or refinancing, and as soon as you do that your points are just wasted money.
If you imagine a future in which the stock market starts to produce consistently worse-than-7% gains, then you are probably also imagining a future in which interest rates have dropped, so you're no longer stuck paying 7% in that scenario anyway. Having slightly over 20% equity in the house allows you to refinance without having to kick in extra cash, even if the housing market slumps a bit. The BIGGEST mistake you can make in this whole decision is failing to refinance when rates are lower.
Disclaimers/personal baggage:
1) I bought my first house in 1998, and interest rates have trended downwards ever since. This accounts for my assumption that no one loan will last more than a few years -- I've only owned 3 houses but have had 10 or so different mortgages.
2) I live in constant fear of the wolf at the door, and always keep a couple of year's salary available as a hedge against disability or other forms of unemployability. So I can't really imagine cashing in your $250k which I would need as a security blanket.
3) I'm not a tax or mortgage professional, just a compulsive optimizer.
posted by eraserbones at 12:36 PM on February 27 [2 favorites]
Can you afford a 15-year mortgage instead of 30-year? An extra $2k a month saves $500-600k in interest over lifetime of $750k loan at 7%. Personally I'd forget about the cashing in stock complication, then play the capitalists' game as designed by putting 20% ($200k) down and stash the extra $50k you have saved to guarantee you have the first 4 years of extra mortgage payments covered.
posted by Press Butt.on to Check at 6:21 AM on February 28 [1 favorite]
posted by Press Butt.on to Check at 6:21 AM on February 28 [1 favorite]
Also I think your choices will be much easier to think about once you have found an actual house you want to buy and have actual numbers to work with.
posted by Press Butt.on to Check at 6:27 AM on February 28
posted by Press Butt.on to Check at 6:27 AM on February 28
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I was prepared to put 20% down, but my loan guy sat down and crunched the numbers with me, working through a few different scenarios, and for my situation, 13% down payment was what made the most sense for me. PMI ended up costing less than Netflix and a takeout pizza once a month, and now a few years into it my PMI burden is over. So for me, in my situation, the cost of PMI was worth it to have that extra cash on hand for living in my house.
Your personal situation may vary, but the best way to find out how variable your personal situation is will be to talk to a professional about your very specific situation.
posted by phunniemee at 8:21 AM on February 27 [4 favorites]