Ask the Readers: Save for a Down Payment, or Put Money into Home Equity?
Published on - March 14th, 2007 (Modified on - July 27th, 2009) (by J.D. Roth) Matt has a question about the best way to save for upgrading his house:
My wife and I bought a small house before our wedding, and we know that eventually (say, within the next five years) we’ll need to move. We’ll want to start a family and will need more space. We purchased our current home with an 80/20 loan, instead of putting down the traditional 20% down-payment. At the time we could afford the payments (and we still can), but just didn’t have the money saved up.
We’re now in a position where we’ve got some financial options — we’ve paid off all our debt (credit, student loans, car loans). Knowing that we have to move, would it be better to pay off the 20% mortgage prior to moving, that way we’ve built up equity and can use that toward the downpayment on our new home? Or should we take the money that we would’ve used to pay off that 20% mortgage and use it to save up for the downpayment directly?
For what it’s worth, our mortgage is about 6% interest. The next house we’re moving into, by the way, will be our last house ever (barring unforeseen shifts in career or any ensuing global chaos).
This is a subtle question. On the face of it, it seems like a better idea to pay down the HELOC (which is the form I’m assuming the 20% mortgage takes). Doing so nets a 6% return on investment. Saving the money instead would probably only yield around 4% (if placed in a high-yield account or certificates of deposit).
On the other hand, the interest difference is small enough, and the time frame is so short, that Matt may want to consider the flexibility he’d gain by having the money in liquid investments (such as a savings account).
When we bought this house three years ago, my bank allowed me to take out a home equity loan to get money for a down payment despite the fact I intended to repay the loan in only two months. The bank’s lending rules prohibited this maneuver, but my loan officer processed the loan anyhow, and told me not to mention my intentions to anyone else. I would have rather had the money in a savings account, ready to be put to use.
As I say: this seems like a subtle problem. I’m not sure there’s a best answer. That’s where you readers come in. Do any of you have experience with a situation like this?
(Ryan asked a related question in January: How do you buy one home while selling another?)
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The nice thing about rolling your first home into your next home, is the utilization of the equity as a downpayment. Thus, negating a cash downpayment. So, effectively this writer should cover the 20% with his current home.
Here is what I would recommend. Banks want to see some cash in the bank. If he doesn’t have an emergency fund, this should be top priority. Eventually, building up an account with 6 months of living expenses. This will show that he is a solid prospect.
Then, if I was him, I would take all other extra dollars and pay down the HELOC. This move would increase his down payment.
With a larger down payment and the look of security with his savings – he will be better equipped to “pick” the mortgage of his liking, instead of “taking” what they offer.
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Hi J.P.,
We had a similar situation a few years ago when we refinanced (to a fixed 4.75/15yrs). We put a small amount onto a HELOC, including the closing costs of the re-fi. The problem was that the HELOC was not a fixed rate, and as we watched it rise (almost a percent a month after the initial 3 month or so intro period) from 1% to nearly 7%, we decided to pay it off.
Long story short – if the 20% mortgage is not fixed, it is better to pay it off or at least watch the rate carefully.
Lisa
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You could ask the same question this way – If you currently had 20% equity in your home, would you go out and borrow another 20% at 6% so that you’d have $ for a down payment?
If the answer is no, then pay off the 20% loan and start saving additional money for a down payment with your income. Hopefully the value of your home will increase in the next few years, so your equity will also increase. If you add that to the additional savings, you’ll be in great shape.
If you use the 20% as a down payment I think you’ll be giving yourself a false sense of how well you are doing. You really haven’t “saved” anything – you’ve just moved money from your home to your savings account.
My wife and I bought our house with an 80/15/5 loan in 2002. We aggressively paid off the 15% and then we closed that line of credit. As I read about people struggling to pay their HELOC type loans due to rising interest rates, I feel very strongly that we made the right move.
-J
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Could he do both? If there’s not a pressing need to move in the next few months, he could pay off the 20% now, then take some time to save the same amount before taking on the new home payment. Any chance of a delay?
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Jag wrote: “As I read about people struggling to pay their HELOC type loans due to rising interest rates, I feel very strongly that we made the right move.”
This is an excellent point. When we bought this house, our home-equity loan was a short-term thing and the interest rate didn’t come into play as a consideration. It was a move of neccessity.
But now that we’re in it, the HELOC I carry (which represents former credit card debt) is a burden, and especially because of the adjustable interest rate. That rate has jumped from arount 6% to over 9% in the past three years. That’s alarming.
Paying down that HELOC is now my top priority. I’ve shoveled money at it the past few months, and now have it down below $15,000. As I’ve said many times before, my goal is to have that thing eliminated by this time next year. That’s ambitious, but I think it can be done.
It sounds as if Matt and his wife are good at planning for the future. This probably means they’ll have plenty of time to take the money out of their home in order to use it for a down-payment. Good advice, Jag.
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I agree with Jag Nogg. I havent purchaed my first home yet, but this seems ilke the best option. Once you pay off the HELOC, you have that plus the additional equity from any appreciation in property value. If you still want to use the original 20% HELOC value as a down payment, you can pocket the additional appreciation. Have you done an appraisal on your house recently? If you haven’t, try one. See what the house is worth now. I think they run about $300. There are a few sites that might give you free estimates though.
Good luck
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Just answer ONE question – can you make more than 6% investing the money elsewhere at an acceptable risk?
I have an Interest Only mortgage at 5.25% because I invest the difference and make 15%. Always put your money where it yields the best.
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On the other hand, saving for a down payment in the form of cash rather than paying down the HELOC means more flexibility when it comes to closing on your new place. If you find a place you really love and need to close on it quickly, you can do so with your cash savings, rather than having to wait until the sale of your current home closes (or having to hassle with a bridge loan).
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Take your time – housing looks due for a correction at this point, and the subprime meltdown will cause prices to drop.
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I’m surprised that the 20% of the 80/20 is really at 6%. What’s the 80% at? 6% seems awfully low for a lender that has no collateral.
Assuming you’re going to sell at the same time as buy, I’d make sure you have enough to make the initial payment to the escrow account (in my part of the country $1000-2000 seems to be the norm). Then I’d put the rest into the debt with the highest interest rate.
Hopefully your current mortgage + your increase is close to the amount you will be paying on the mortgage for your new house, so you’ll have less sticker shock when you move.
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My question is, are you and your wife currently maxing out your retirement accounts annually? If not, this in my opinion is your best option. I would advise minimizing your tax burden! Avoiding Earned Income Tax gets you a better return than both putting the money toward your Heloc or a savings account.
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I agree with the person who suggested paying off the HELOC and then saving additional funds for the larger down payment. Otherwise, they aren’t ahead at all. What’s the hurry to buy a new house? They are talking about starting a family–that’s a ways from having one. Make sure you have the money for the house or you will have to work so much to keep up with the payments that you won’t be able to enjoy the kids. Otherwise, kids are remarkably adaptable–enjoy them in a smaller space.
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I’m the original writer of this question, and just to give some background:
The 20% is NOT HELOC. No variable interest rates involved. You’re right that we considered putting the savings into a high-yield savings/CD. Probably earn about 4-5%. The reason the interest rate is so low for the 20% is that our housing costs are about 15% of our income, as opposed to the typical 25-35%. It’s a VERY small house, though, hence the desire to move before the advent of kids.
We are contributing to retirement, have an emergency fund, etc. The big question for us is that we’re leaning towards saving, then maybe upping our payments just a bit, that way we have some ability to “move fast” on the market when the time comes and we find the right house, as opposed to waiting for our house to sell.
Keep the suggestions coming. They’re most helpful!
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For inspiration on living in a smaller space with a baby: check out this space on apartment therapy. http://www.apartmenttherapy.com/ny/9-month-cure/9-month-cure-thank-you-014734
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Why a bigger house? Do you want to keep up with the Joneses?
Save and repay as much as you can before you have the (first) baby. Study ways how to make the most of the space you have. Declutter.
A baby does not need much space in its first years.
That gives you and wife options to stay at home for some time, work flexible schedules and… and… and… This all might be more valuable for your family than “more space”.
More space tends to be filled with new furniture, clutter and other items. More space creates expenses for heating, cooling and – worst of all – CLEANING!
(Not to mention TAXES)
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You should get your loan officer on the phone and ask him or her which route is best. The two paths are nearly equivalent in terms of yield, but if one direction makes it easier to secure the next loan then that may lead the decision.
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If you are sure your old house has appreciated and will cover your old loans and most of the fees for both buying and selling, I would think hard about saving your new downpaymetn outside of your loans.
The reason is flexibility for the new purchase. If you are depending on the sale of your old home to payoff your loans and fund your new down payment you will be tied to closing at the same time.
I had to do that this last year and it was difficult in our sliding market, it put pressure on us to close quickly and reduce our price when we found the house which we wanted to move into.
Finding the “ideal” piece of real estate is a game of being both ready to pounce and able to wait for the right deal. If your next downpayment is locked up in your old home, you lose the ability to pounce (unless your 20% is in a HELOC that has enough room in it to write a check for your new downpayment)
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If you want flexibility, it is better to put your money in something that is liquidable. If you want the best value, then pay off the second mortgage and take the money that you would normally use for your payments and put it into other investments.
http://wisdomfrommywife.blogspot.com
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Matt:
It sounds like there may not be an absolute right or wrong answer here, and neither option will make or break your financial situation. You are already doing a lot of things right, maintaining an emergency fund, saving for retirement.
If the dollars in question are going into the new house either way and you are not convinced with one option over the other, perhaps split the difference and put half in savings and half toward the debt. You can always take a chunk of money out of savings and pay down more debt at any time. Go with what your are most comfortable doing because there’s value in comfort too.
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Never having bought a home in the States, I’ll ask a naive question: how much of a downpayment do you need to avoid having to pay for mortgage insurance? Here in Canada it’s 25 percent, not 20 percent. Mortgage insurance can be expensive (buying a home for $150,000 and putting down only 15 percent will cost you over $2,000 in mortgage insurance premiums), so if you want to avoid that you may have to aim for a higher downpayment. But as I said, maybe this isn’t an issue in the US.
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Pay off the 20%. Never underestimate the freedom of having less debt. It will change the way you look at the world.
Guaranteed 6% return on your money. Also, you build the precedent in your marriage for paying off your house early.
If you want more flexibility, build up your emergency fund bigger. Why do you need to move fast? Be patient, there’s always more houses.
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A couple of issues (some covered by others):
1) PMI – mortgage insurance (you likely are paying insurance if you didn’t put 20% down.
2) Tax benefits (difference may be too small to care about), $250,000 or $500,000 (if you are married, sounds like you are) in profit from the sale of house #1 is tax free, you’ll likely be paying taxeson whatever liquid investment.
3) Don’t get sucked into the escrow black hole (unless you are so bad at managing your money that you won’t pay your real estate taxes or insurance on time). I’m regularly surprised by the high number of people who hand over their hard earned money in the form of escrow payments to their bank when they could be earning interest on that $ if they socked it away each month. Last year (2006) I earned over $1000 in interest on my escrow money (4 insurance policies, 3 real estate tax bills on 4 properties). Yes it requires work and org. to move money into specially designated accounts each month and to keep on top of when insurance and taxes are due (use your calendar) but that’s $1000 in my pocket instead of the bank’s pocket. The bank/mortg. co. will try to tell you that they are legally required to escrow those monies for you – ask them to cite the statute (b/c they are full of it), you’ll have to tell the bank 10 or 12 times that you are going to do your own escrowing and you may have to prepay the escrow amounts for the first payments depending on when you buy the house and when the payments are due (i.e. you buy the house in June and taxes are due in November) but don’t let them sucker you into an ongoing escrow arrangement.
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There’s one other mitigating factor in the interest rates here. Mortgage interest on your primary residence is income tax-deductible. If you’re paying 6% interest on the debt, and you typically pay 20% federal income tax, you can consider that loan’s interest rate a little under 5% instead. Basically, it’s a break-even proposition to put it into a savings account that would yield 5%. If the loan is adjustable and the rate can rise, I would prioritize it first. Otherwise, it’s basically a toss-up.
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As far as tax deductions:
Mortgage interest is only (practically)deductible above the standard deduction, which is over $10,000 for a married couple.
Of course itemizing does open up the possibility to deduct more things, but usually the mortgage interest is the primary factor. I don’t think it is accurate to suggest mortgage interest has a dollar for dollar tax benefit.
I know plenty of people who own houses and don’t even itemize- because they have low/reasonable mortgage payments.
I think there are many good arguments for carrying/incurring expenses, but tax deductibility is rarely one. Especially when it results in spending extra for the “savings”…
Not many people have a federal rate of 20%+.. I just consulted current tax tables and for me to have a 20% overall Federal tax I would have to make about $150,000. For any of my money to be taxed at over 15%- ~$80,000.. For any to be taxed at 33% ( a common savings rate people like to toss around when arguing tax deductions) I would have to make over $208,000.
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Here’s my two bits… My family just relocated from Texas to Oklahoma, with the complete job change, home sale, etc. The experience taught me that it is sometimes preferable to have the extra liquidity when you’re in transition. If you pay down the 20% loan on your original house, it is difficult to get access to that money again quickly.
In our case, we found the “perfect house” in our new location, but our old home hadn’t sold yet. The sellers of the home we wanted refused to take our offer, which of course we made contingent upon our old home’s sale. However, we had a low enough debt-to-income ratio, that we actually qualified for two mortgages – clearly not something that we wanted to sustain for long – but we took the risk and got the house we wanted. Ten days later, our old home sold, and we’re happy with the results.
… all that to say that if we didn’t have the extra liquidity during the transition, we might not have been able to confidently cover two mortgages, plus the uncertainty around closing costs, financing, and other short-term home improvements.
My recommendation in a nutshell: hold onto your cash as long as you can at this point, until you size up all the options for how to spend (or save) it – don’t lock yourself into a course of action too early.
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