Want To Be More Conservative With Your Mortgage Financing? Make A Smaller Downpayment!

Equity investments (a.k.a. downpayments) in Real Estate earn a 0% Return On Investment (ROI). Surprised? Well, let's understand the math: Assuming a 5% annual rate of appreciation, a home purchased for $400,000 will appreciate to $420,000 in one year. If the homeowner originally invested $80,000, or 20%, theoretically, the ROI is 25%. This is true because it appears that the initial $80,000 downpayment yielded $20,000 in equity appreciation. However, it is important to note that the $80,000 had nothing to do with the $20,000 appreciation.

If the homeowner had not invested the $80,000, the home would still be worth $420,000 in one year. In this instance, the ROI is infinite because the homeowner invested nothing and yet received the same $20,000 in appreciation. However, we must take into account that the rate of borrowing will be higher in this example because there is no downpayment.

Using a 7.00% Home Equity Line of Credit (HELOC) to finance the $80,000, the payment will be $5,600 in Year 1. The second example yields a return of at least 357% because the $5,600 additional payment yielded the $20,000 in appreciation.

There are other ROI considerations for the homeowner. A home is a non-liquid asset, meaning that once the homebuyer's money is invested in the home, there is a real cost to extracting the money as cash.

The initial $80,000 investment, therefore, is "lost" -- tied up in equity until the homebuyer sells, refinances, or takes out a HELOC.

Not only is the initial $80,000 investment earning 0% return for the homeowner, it is unavailable for other investments which could be earning 2% as a Money Market Mutual Fund, 5% as a Certificate of Deposit, or even higher returns with other instruments.

Therefore, the opportunity cost of making a downpayment is further depleting ROI for homeowners.

A "conservative" person will read this argument and say, "That's too risky. I am too conservative to make small downpayment."

I can buy that argument, but those two sentences are not related at all.

A true "conservative" person will recognize that the smaller the amount of downpayment, the larger the risk that the bank is taking. As the homebuyer's downpayment shrinks, so does his personal exposure.

"What if the property depreciates! Then I'll be exposed!" they'll say next.

That's true, but if the property depreciates, there is no advantage to your initial equity investment anyway. I'm sorry, but Out of sight, Out of mind is no way to manage your equity investments and finances.

The reality is the conservative financing option is to make smaller downpayments. In doing so, you push risk to a third party -- the bank! -- and you remain very liquid.

Liquidity is the true goal of a conservative investor.

I am not arguing against making downpayments on properties, for the record. But, for people who claim that Real Estate is an investment, they should treat it as such. This is consistent with my philosophy that a mortgage should be one component of a larger (managed) financial plan.

The advantages to making an equity investment in property is that the resultant monthly mortgage payment is lower. If a homebuyer's monthly cash flow is low, but their investment capital is high, there is an argument for putting 20% or even more into the property. There is also tremendous psychological inertia to overcome with respect to putting less than 20% into a property. Some people just won't hear it any other way.

That's fine -- different strokes for different folks!

Okay, with all of this said, there is actually a return on the equity investment. That return is the money saved by not paying interest on the higher loan amount if no downpayment is made. That means that the homebuyer saved an amount equal to the interest rate on the loan, or 7.00% in this case. So which is the more conservative strategy; 1) Investing a large downpayment to secure a lower monthly mortgage payment, leaving little money in reserves, or 2) Investing very little or no downpayment, paying a slightly higher monthly mortgage payment and leaving a large reserve to cover the increased payment as well as life's inevitable unscheduled emergencies?