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Alternatives to a large down payment

The good news is you have many mortgage options. That's also the bad news. 

Selecting a mortgage is one of the biggest financial decisions an individual or family can make. It is crucial to see how your choice affects your total financial picture. Many borrowers shop just for the lowest rate on the loan program they think is right for them. The Internet has further turned mortgages into a commodity according to many. The lowest rate on the wrong program is far more costly than a competitive rate on the program that best suits your needs.

Rates are important, but you also need to consider a host of other variables, including taxes, term, fixed vs. adjustable, rate locks and, perhaps most importantly, the loan amount.

The size of the loan is perhaps the most frequently neglected question. Buyers commonly shy away from larger mortgages because they don't understand the alternative uses of their money. Most people fear debt, sometimes to a fault.

Homebuyers often have better alternatives for their money than putting it toward the purchase of a house merely to cut the size of their mortgage. For example, many relatively safe tax-exempt bond funds pay a better after-tax return than you would get from paying down your mortgage.

A family in the 28 percent tax bracket actually earns 9.44 percent (after taxes are figured) on a municipal bond fund paying 6.8 percent. So at mortgage rates below 9.44 percent, you should consider taking out the biggest mortgage possible.

Home prices have escalated in recent years. Many homeowners find themselves with relatively small mortgages relative to the market value of their homes.

An example helps bring the point home.

You buy a home valued at $250,000. You can afford to put $150,000 down. That leaves you with a $100,000 mortgage at say 7.5 percent. You could also put $50,000 down and take out a $200,000 mortgage.

You could take that $100,000 of free cash and put it into a municipal bond fund yielding 6.8 percent. You’ll probably end up making more money that way in the long run.

Look at it this way; the borrowed $100,000 would cost 7.5 percent minus the tax deduction (let's say 28 percent) of 2.1 percent, netting the cost out to 5.4 percent. The difference between the two options (6.8 percent municipal bond and 5.4 percent net cost on the mortgage) is 1.4 percent.

The savings on $100,000 would be $1,400 per year. The higher the tax bracket the greater the savings. Be careful not to borrow more than 80 percent of the value of your home or you will need to pay a monthly private mortgage insurance premium that would negate the savings and is wasted money. The mortgage tax deduction ends at $1 million for first mortgage liens on primary residences. The tax deduction for second liens is capped at $100,000. Mortgage rates can be slightly higher for "jumbo" loan amounts, loans over $300,700. This is the current limit for "Jumbo" loan amounts.

Many other alternatives can be worthwhile. Paying off higher rate or non-deductible debt can save a lot of money. Individuals who have chosen more aggressive though riskier approaches have found them to be very profitable.

The S&P 500 stock index has averaged a return of about 15 percent per year for the past four years. After a capital gains bite, the net percentage earned after tax would be 12 percent. This is a much greater return than the 5.4 percent net cost of borrowing on your mortgage. In fact, the S&P 500 has averaged a greater than 15% return for the past 30years. That means your money should double every five years. This can have a dramatic effect over time. Let’s look at a couple of examples:

I see many people using a home loan refinance to save money by lowering their monthly payment. That’s great, but the monthly savings is often spent frivolously and not used for a long term, meaningful investment like college or retirement. Think about keeping your payments the same but borrowing a higher amount. So if you owe $200,000 and are saving $200 monthly by refinancing, you could borrow $230,000 and keep the same payment. That $30,000 could be used to invest for your child's college education. Based upon historic rates of return for the S&P 500, that $30,000 investment would be worth $240,000 in 15 years. That’s a great way to save for college.

A mortgage is typically the largest single financial move people make and should be the centerpiece of any good financial plan. Use it to create wealth for yourself. Let’s say you planned to take out a loan of $200,000 on a home worth $350,000. If you make a down payment of just $100,000, you can invest the extra $50,000. At an historic rate of return of 15% annually, that $50,000 investment would be worth around $400,000 in 15years. That's enough to pay off the mortgage completely in half the time and give yourself a bonus of $215,000. That is a nice way to reach your retirement goals.

A mortgage can be a great financial tool. It should not be obtained the same way you buy a book online. It's your money.

I have an article "Buying your home in 2008" by email explaining negotiating strategy in today's market.

As a Certified Mortgage Planning Specialist, I offer an analysis of your situation today can make suggestions on how small changes in how your consumer and mortgage debt is structured today can have a life changing effect in the years to come.  Read more about this free, no obligation service.