Making A Large Downpayment Isn’t The “Conservative” Mortgage Choice You Think It Is

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Equity investments in Real Estate earn a 0% return on investment (ROI).

Surprised? Well, let's understand the math (assuming 5% annual appreciation):

A home purchased for $400,000 will appreciate to $420,000 in one year. If the homeowner originally invested $80,000, or 20%, the ROI is 25%. This is true because the initial $80,000 downpayment yielded $20,000 in equity 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. However, we must take into account that the rate of borrowing will be higher in this example.

With a 7.00% HELOC drawn on 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 $20,000 in returns.

There are other ROI considerations for the homeowner. A home is an 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 opens a Home Equity Line of Credit.

Not only is the initial $80,000 investment earning 0% return for the homebuyer, 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 homebuyers.

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, right. 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 completely as liquid as possible.

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 monthly cash flow is low, but 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 -- diff'rent strokes for diff'rent folks!

Okay, with all of this said, there is one way to earn a return on investment with equity investment -- selecting a loan program that recasts monthly.

Think about the traditional fixed loan program -- a $100,000 30-year fixed mortgage will cost $665.30 each month at 7.00%.

If the homeowner wants to invest an additional $300 towards principal each month, the loan's principal will be repaid in 20.5 years.

The mortgage payment remains constant until the loan is paid in full.

For loans that recast monthly -- most notably, Interest Only loans -- the mortgage payment is calculated each month by dividing the interest rate by 12 months, and multiplying the quotient by the remaining loan balance.

Therefore, the same additional principal investment schedule will lower the homeowner's monthly obligation month over month. The 1st payment of $583.33 becomes $576.33 at the end of Year 1.

The ROI for additional principal payments on recasting loans is equal to the interest rate on the loan, or 7.00% in this case.

Sounds like a conservative investment to me.