Better to make extra principal payment in first year versus putting more into down payment?

Question

For a mortgage I considered putting down X and then said, let me reduce my interest over the life of the load by paying an addition Y. However, when I compared the original total interest with down payment X versus X+Y the total savings on interest was less than Y. This at first seemed odd to me since the general thought it more down, less borrowed, more saved.

I then decided to see what happened if I put the Y into a CD and then paid it as a large extra payment the month after the CD came due. When I did this, the total interest paid over the life of the loan dropped significantly. I then use an extra payment calculator and noted that when if instead of making my down payment X+Y, but just paying Y as an extra payment in month 1 without even investing in the CD I still saved significantly on total interest.

There are other discussions on more down payment versus investing the money, but I am trying to find the flaw in my logic of putting a smaller down payment but making a huge extra payment in month 1. I've read some banks limit the total amount of extra payment you can make in a year, but if you can stay within those bounds, it seems like you can really save on interest.

The downside is that by borrowing more instead of the larger down payment your monthly mortgage bill will be higher, but if you can afford the difference monthly than it seems like a good plan as long as you get the same interest rate.

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Let's use the following scenario as an example:

• House costs $500,000
• Buyer has $150,000 cash available
• If buyer puts down $100k, interest rate is 4.5 / 30 year fixed
• If buyer puts down $150k, interest rate is 4.5 / 30 year fixed
• For this scenario, lets ignore closing costs, taxes, hoa, etc. (though a more expensive loan may result in higher closing costs)

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Scenario 1: Put down $150k

• Loan amount: $350k
• Monthly cost: $1,773.40
• Total interest over 30 years: $288,423.49

Scenario 2: Put down $100k, pay the extra 50k in month 1

• Loan amount: $400k
• Monthly cost: $2,026.74
• Actual number of payments at monthly cost: 270
• Total interest paid if no additional payments: $177,217.50

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What are the pros and cons / and other considerations?

Answer 1

There's literally no reason to wait one month and then put that extra $50k towards your principal. You're just paying interest on $50k for one month, for no reason (unless you may need that 50k for some emergency in that 30 days after you buy the house.. then it might make sense). Moreover, you're not just paying needless interest, you're locking yourself into a higher monthly payment ($253 higher, to be exact), again for no reason. It's strictly worse than using the 50k for a larger downpayment.

The REAL difference between these scenarios, and the source of the lower total interest, is the higher monthly payment of the second scenario. If you want to pay less interest over the life of the loan, why not just put down the full $150k and voluntarily bump up your monthly payment by an extra $253 per month, but only when you have the spare cash. You'll pay off your loan faster, and pay less interest, but you will have the flexibility of NOT paying that $253 extra in months where your cash flow struggles.

Life can bring unexpected costs - don't lock yourself into the extra $253/month unless you're getting a real benefit for that inflexibility, like a lower interest rate.

Edit: I should add, if you can afford the higher monthly payment of $2026, it's worth considering only putting $100k down, and then doing something entirely different with that $50k extra. e.g. invest in a low-cost stock index fund for a couple decades, especially if you can put it towards a tax-advantaged IRA. It's pretty likely a stock investment over 20-30 years of the mortgage will earn a return that beats the 4.5% "return" you'd get by paying it into your mortgage. The average annualized return of the S&P 500 is 9.8% before inflation. That crushes 4.5% for your mortgage rate. But if you prefer a low-risk and non-liquid investment, go ahead and put the $50k extra towards your down payment.

Answer 2

First off, your math is wrong. I'm pretty sure you accidentally started Scenario 2 with $350K (instead of $400K) and then made a $50K payment in the first month. By my calculations, starting at $400K and paying $50K after 1 month should put you at 280 months and total interest of approximately $215K.

Now to compare apples and apples, if you do a loan for $350K at 280 months (which is close to the same payment), it'll work out to nearly the same amount, as expected. (You actually can reduce it to 279 months to get even closer to the actual monthly payment you'd be making with 400K loan, and then you save a little bit in interest, as expected.)

Conclusion: no need to get fancy, you will always save interest if you put more money down. You just weren't comparing the right numbers.

Answer 3

Scenario 1 vs Scenario 2

By deferring the $50k from down payment until the first month you save over 111k in interest payments over the life of the loan. However, you must now pay about $290 more per month. You could pay to recast the mortgage at some point to lower the monthly payment, but from the pure interest perspective it seems like you save money in the long term.

On the long term perspective, if you can afford the higher fixed cost (or maybe you will end up refinancing at some point) you have saved a lot of money from interest. Had you just kept the monthly difference in your pocket earning no interest over the 270 months you would have about $78,000 more cash. However, if you consider starting at 0 and putting the $290 each month into investments at a consistent earnings rate 3% for the 270 month you will have $114k. If you have a mix of CDs and stocks 3% seems possible over the long term.

The other consideration is that your mortgage is $0 after 270 months.

If you have the discipline to invest and not spend your monthly difference, you may be able to do better and keep more money liquid. However, to get the 3% at least some of your investments will have to be in riskier investments than savings and CDs.