Down Payment and PMI - Information and Advice

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How Big a Down Payment?
by Arnold Kling

Two people contacted me with questions about how much to put down on a house. Since many people have these types of questions, I decided to turn my answers into an article and post it here.

Case 1--Use VA Loan or not?
The first question comes from Scott, who is in the military and therefore is eligible for a VA loan. He asks,
I was wondering how you view VA loans and whether or not a large down payment should be put on a VA loan?

Would an ARM mortgage be better than a VA loan (all of which I've seen are fixed rate)? I do have $20k available for a down payment, but the average home cost in my area is $140k.

With VA loans, the government insures the loan, so you can make a low down payment and still not have to pay private mortgage insurance (PMI). This diminishes the advantages of making a larger down payment.

If you were not eligible for a VA loan, making a large down payment would help reduce your PMI costs. I personally still would lean toward making a large down payment, but if you do choose a VA loan you might hold back some of that $20,000 to use in case of some other financial emergency.

Instead, you need to use a leveraged strategy to avoid PMI entirely.

Click here for information on using two loans to avoid PMI and reduce your mortgage payment.

It might require a pretty sharp pencil to choose between a VA loan and a non-VA loan. Once you can afford a 10 percent down payment, you are in the range where the cost of PMI may be less than the origination fee that you would need to pay to get VA financing.

Because you are in the military and expect to relocate in 3-6 years, a five-one ARM conventional ARM (an adjustable rate mortgage that stays fixed for the first five years and then adjusts annually thereafter) may very well cost somewhat less than a VA loan.

Case 2--the lucky chap
The second question came from Ken, who apparently has done very well for himself. His question was,
Suppose I have $500,000 and the minimum price house that would be adequate size costs $300,000.

Is it better to buy the house with the money or leave it in the stock market and borrow the money?

The conventional answer that a finance professor would give is that you should prefer to have a balanced portfolio. If you have $500,000 in stock and you sell $300,000 to pay for a house, you will be changing your portfolio to have 60 percent in real estate and 40 percent in stocks. The professor would tell you that this is too heavily weighted in real estate.

However, real estate allows you to leverage your down payment much more than you can with stocks. With a 20% down payment, you have 5-to-1 leverage.

With stocks, the best you can do is 2-to-1 leverage.

In addition, stocks are riskier than real estate. So, it's actually more prudent to be more heavily weighted in real estate than stocks.

Click here to explore ways to leverage your down payment.

50-50 stocks and real estate scenarios
Suppose that you prefer to have 50 percent exposure to real estate and 50 percent exposure in stocks. Then one approach would be to sell $200,000 in stock, and borrow the remaining $100,000 to finance the house purchase.

You would have $300,000 in stock and your $300,000 house (you own the appreciation on the entire house, regardless of the size of your down payment).

However, $300,000 is not the only level at which you can achieve 50/50 balance. You could sell $150,000 in stocks, put $100,000 down on the house, and invest another $50,000 in a Real Estate Investment Trust. That leaves you with $350,000 in stocks and $350,000 in real estate.

What if you want to have 70 percent of your assets in stocks, and 30 percent in real estate? This might be closer to the finance professor's recommendation, but the challenge here is that because your lifestyle requires a $300,000 house, you are forced to have a minimum of $300,000 in assets in real estate.

What you would like to do is increase your exposure in the stock market, to $700,000. There are ways to do this, but they are in the more advanced finance course.

Briefly, you would liquidate some of your stocks to make the down payment, but then you would buy more stock on margin, or buy call options. Either of those strategies can increase your leverage.

Finally, I have to say that for the past two years I personally have been holding a smaller share of my assets in the stock market than the conventional wisdom in finance would suggest.

Given my personal bearishness, it is a bit awkward for me to discuss ways of maintaining a high proportion of one's assets in stocks. However, that is the conventional wisdom.

Related Pages

Zero Down Mortgage Loans - How to buy your home with no money down and no PMI - Use zero down mortgage loans to avoid paying private mortgage insurance and lower your loan payments.

Down Payment and PMI - How to leverage your down payment - Buy a larger home where your equity grows faster and avoid PMI using a two-loan strategy. Learn the 100% financing technique. Avoid paying for private mortgage insurance (PMI) on any mortgage where you put less than 20% down.

PMI Insurance - Information about PMI insurance - How private mortgage insurance works - Save big by eliminating PMI from your loan today.

Interest Only Mortgage Loans - Get the scoop on interest only mortgage loans - Reduce your payments to a minimum level - Discover how to grow home equity without paying to create it.

Home Buying Mistakes - Tips on buying your new home - Avoid these common home buying mistakes that will cost you thousands extra.

Online Mortgage Broker - How to use an online mortgage broker to save big on your next home loan - Advice on what works and what to avoid.
 

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