Down Payment how much is too much?

Down Payment how much is too much?
This is one of the oldest questions faced when purchasing real estate. The rule of thumb has always been to put down 20% of the purchase price if you can. Of course, if you had more available, then you were advised to increase the amount. The general principle behind a large down payment is that you will have a smaller mortgage and therefore a smaller mortgage payment. While that may be true, the operative question is: does a large down payment make the best use of your money?

In order to address this question, we must first visit a common misconception regarding home equity and its rate of return. No matter how much (or little) equity you have in your house, the rate of return is always the same: zero. This is important to understand because you would not put your hard earned money into a mutual fund that advertises a 0% rate of return, so why put it into your house? It is dead money that provides the same return as it would if you had literally buried it in your backyard or put it under your mattress.

Now you might think: How is that possible? I put down $100,000 on the purchase of a $500,000 home five years ago and it is now worth $600,000. This is a 100% return on my investment of equity. The common mistake most people make is confusing return on equity with the appreciation of real estate values. True, the house went up in value, but you would have realized this gain regardless of whether you had a mortgage on the property. Indeed, you would have realized it even if you had financed the entire purchase. A home’s appreciation in value does not depend upon the size of the down payment. Real estate values go up and down irrespective of the size of down payments and mortgages. Real estate value is a factor of market supply and demand. The analogy is that boats on the bay will rise and fall with the tide no matter how big or small they are.

Let’s tell the tale of two brothers ready to buy their next home Smart Sam and Nervous Nick. Each has $150,000 available to use as a down payment and are buy a $250,000 home. The Nick decides to follow conventional advice and make a big down payment to reduce his monthly mortgage payments. He will only have a $100,000 mortgage. The Sam on the other hand is privy to the smarter way to purchase his home and he only places $50,000 down. He then invests the remaining $100,000 he had available in a long term investment account. The illustration further assumes that both homes will appreciate at 4% over the next 10 years.  It further assumes 6.5% growth on the money invested in long term investments (most indexes average over 10% per year historically).  They both take out an interest only mortgage at 5.5% (this makes the math simple to follow).  Nick will invest the difference in monthly savings into a long term investment as well.  The monthly difference is $390 at 6.5% growth.  Both brothers are in the 15% tax bracket.

TEN YEARS HAVE PASSED
Projected 10 years into the future both homes will appreciate to the same value of $370,061. Remember, the value increases or decreases based upon market demand. It has nothing to do with the size of the mortgage or the amount of equity in a home. If they both then decided to sell, at the closing they would both have the same gain. Nick would pay off his mortgage of $100,000 leaving him with $270,061 from which they will deduct their original down payment of $150,000 leaving them with a gain of $120,061. Sam on the other hand will pay off his $200,000 mortgage leaving him with $170,061 from which he will deduct his original down payment of $50,000 leaving them with a gain of $120,061. As for the long term investments Nick’s account grew to $65,677 ($390 per month for 10 years); Sam’s grew to $191,218 (remember the $100,000 up front lump sum investment).

Nick’s Net Worth $335,738 could pay the house off in 13.50 years

Sam’s Net Worth $361,279 could pay the house off in 10.75 years

As counter intuitive as it seems, this illustration proves that regardless of the size of the down payment, the gain is always the difference between the original purchase price and the future value of the home. After 10 years of the home appreciating at a rate of 4% per year, both homes have gained $120,061 in value despite the different down payments. This analysis demonstrates that home equity has a 0% rate of return. One thing I would like you to think about, you would not put your hard earned money into a mutual fund that advertises a 0% rate of return. Why would you do the same with down-payment funds?

Now that we have illustrated this critical point, let’s get back to the original question: how much should you put down? Don’t put all of your money down on a house, put as much as you need to, so that you are able to afford the payment.

Do You Have a Sub Prime Loan?

Several factors contributed to the real estate bubble that just recently helped expose the weak links in our economy leaving many desperately seeking foreclosure help.  Two of the biggest factors include historically low mortgage rates and the constant spreading of the risk mortgage companies assumed when lending to buyers.  There were several ways this was done, but the primary culprit was “bundled mortgages.”

“Bundled mortgages” came into being when mortgage underwriters pooled the promissory notes of many loans into one bond to sell in the bond markets.  These bonds had some value based on the money all the mortgage borrowers were supposed to pay back over the life of the loan.  These financial instruments were then sold to other banks, investment brokers, Fannie Mae, and Freddie Mac.

Everyone in the mortgage lending business was making a lot of money during the boom.  The refinance segment of the business also boomed, with historically low interest rates fueling the phenomenon.

The ability to “share the risk,” that is, sell a mortgage that would normally be considered high risk, to other banks and to the public at large, drove underwriting standards into oblivion.  The mere existence of “ninja” loans, that is loans made with No-Income-No-Job-no-Asset verification should have been a HUGE red flag to everyone.  The rationalization at the height of the market was that anyone could “flip” any house at any time and make an easy profit.  In fact, the housing market conditions briefly supported the notion that anyone could sell any house at any time.

Lenders got more and more “creative” with payment options and types of loans to qualify more and more people…  Some of the common products they conjured up include the aforementioned NINJA, as well as a balloon mortgage.

There never seemed to be any actual “risk” to writing mortgages. Believe it or not, banks and mortgage brokers actually broke existing laws as they squeezed more and more money out of “the market” during this frenzy.  

They offered loans with ridiculous penalties and terms.  They offered 5 year ARMs to people who could afford the low introductory payments under the initial interest rate, but had no hope at all of being able to afford the mortgage after the rate invariably went up.  They lent to people with too much credit card debt.  They wrote “negative amortization” loans that ensured the amount due would be greater than the home’s value in three years. They levied penalties at at closings.

These practices gave rise to the term “predatory lending.”  These practices are and always have been illegal.  Predatory loans cause sudden financial crises for homeowners through penalties and higher payments, often causing families to lose their houses, or be forced into insolvency.

If you got a “predatory loan,” you could actually have a good case in United States Federal Court to get

* Your loan modified by the Court to have lower interest rates,
* Penalty payments repaid to you,
* Legal fees for the lawsuit paid by the bank that broke the law,
* Any negative entries made against your credit rating by the bank removed, and
* Possible punitive damages payments.

Again, this is only if you are a victim of “predatory lending practices,” which requires that your lender actually broke laws that applied to you at the time you closed on your loan.  How can you tell if any of this applies to you, and what can you do about it?

First, because of statutes of limitation, your options are limited if you closed on your mortgage or refinanced before January 2005.  If you closed on your note since Jan. 2005 and you have supporting evidence like copies of emails and letters to and from your mortgage broker and bank, you may have a strong case with a high probability of prevailing.  You can find thorough pre-qualifying questionnaires around the web, and a good one at the page linked earlier in this article, to help you determine your status.  If you appear to have a predatory loan like a balloon mortgage, or you didn’t get translated copies of all the paperwork, there’s a good chance you do have a predatory lender.

You can contact an attorney who knows about this kind of case, or you can contact a company to do forensic audit that would be used as evidence in your lawsuit against a predatory lender.  

Make sure that any forensic audit company is very clear about the cost of their services.  The preliminary review of your loan documents should be free, and they should give you an objective assessment of the quality of your case.  They should be very clear about what their  services will cost.

Any attorney you contact should already be familiar with this kind of case, because it would be very expensive for him or her to do the research on a new kind of case while billing you for his or her time.  When you speak to a lawyer about suing a predatory lender, that attorney should become yours, representing only you, not a real estate company, and be very clear about payments of retainers and fees.  If they have been properly prepared for this kind of case, they should take your case on a contingency basis, only requiring an initial retainer to cover the expenses of the initial court filings.  Virtually all settlements have required the predatory lender to pay all of the borrower’s legal fees.

An attorney familiar with lending laws would know that he should file an injunction against the bank as one of the first items of business.  This freezes your loan until the matter is settled or goes to court.  So, even if your situation looks dire because you can no longer afford your predatory mortgage payments, you could quickly get relief.

Good luck with your case!