Years ago when the Consumer Financial Protection Bureau was created, we had some wacko thought that part of the job of the folks filling its ranks would be to . . . protect the consumer. In some people’s view, this would mean that builders of new homes would no longer be able to dangle the carrot of “free” incentives if the buyer would finance the purchase through the builder’s in-house or preferred lender. To those same people, it just made sense that the CFPB was created to even the playing field and make it so that the consumer got the very best deal available. Well, we were wrong.
Builders ARE allowed to offer incentives for using their in-house and preferred lenders despite the fact that sort of goes against the idea that the consumer is getting the very best deal available. And for most consumers, all they see is the incentive, and this computes to less money coming out of their pocket at closing – and they’re right (sort of). The purpose of today’s article is simple: demonstrate how much money REALLY IS coming out of their pocket as time goes by.
The first example is a gentleman who is purchasing a new home for a price of $555,331. He’s being required to put 10% down, or pay $55,533 out of his pocket at closing. Enter the builder’s incentive of $5,000 to be credited against closing costs – who can argue with that? In this particular case, he wants an interest-only loan, which means that he’s only going to pay interest for the first ten years of the loan – the principal doesn’t get touched if he doesn’t pay any extra in that 10-year period. The in-house/preferred lender offered him a rate of 5.5%, which means that his monthly payment is going to be $2,290.74 – in one year, he’ll be paying $27,488.88; in ten years, at the end of the term, he will have paid $274,888.80. We offered him a rate of 4.75% on the same type of loan, which means that his monthly payment is going to be $1,978.36 – in one year, he’ll be paying $23,740.32; in ten years, at the end of the term, he will have paid $237,403.20. Yes, you’re doing the math correctly, ladies and gentlemen: for a $5,000 incentive at the front end, he’s going to pay $37,485.60 more over the term of the loan. In one year alone, he’s paying $3,748.56, and in two years, that’s $7,497.12 (which is almost .5 times more than the $5,000 he “saved”)! Believe it or not, he went with the in-house/preferred lender for the “free” $5,000.
Now let’s go with a slightly more subdued example. This woman is purchasing a home for $260,000 with a 5% down payment – $13,000 – for a loan amount of $247,000. The in-house/preferred lender offered a $3,000 incentive in exchange for a rate of 5.375% on a 30-year fixed mortgage. This yields a monthly payment (principal & interest) of $1,376.96. We offered a rate of 4.875% on the same loan type for a monthly payment (P&I) of $1,301.86. So far, that’s not that big of a difference, right? In one year, that’s a difference of $901.20 between the higher rate and our rate. It will take 41 months (just under 3.5 years) of paying the higher rate to cover the $3,000 incentive. In ten years, which is the average amount of time someone stays in a home, our rate would save her $9,012 – and yet she went with the builder’s in-house/preferred lender.
In both of these cases, $5,000 and $3,000, respectively, are sizable chunks of money that could cause some immediate “pain” in having to part with them – no argument there. However, if these borrowers stopped for a moment and looked a relatively short amount of time into the future, they would see that they would easily recoup that out-of-pocket money AND THEN SOME. Obviously enough to afford an eye exam.
Buckle up and get ready to have your mind blown! Okay, it’s not THAT mind blowing – some of you might even say, “well, duh” – but it’s still interesting. The New York Federal Reserve’s economists recently published the results of a study: changes in down payment requirements have MORE influence over home buyers’ willingness to buy than changes in rates.
Surveying both buyers and renters, the Fed found that the effect of interest rates may be overrated when compared to even small changes in down payment requirements. The study found:
1.Droppingthe down payment from 20% to 5% increases the willingness to purchase, on average, by 15% among buyers and 40% among renters
2.Decreasingthe interest rate on a 30-year fixed-rate loan only raised the willingness to purchase by 5%, on average
As buyers straddle the fence between BUY RIGHT NOW with a higher interest rate and WAIT AN UNKNOWN PERIOD OF TIME to save 20% of the purchase price, here’s an example to give them a push. Take a look at the numbers for a house with the purchase price of $200,000 with a 30-year fixed mortgage:
WAIT: requires a $40,000 down payment for a total loan amount of $160,000. At an interest rate of 5%, the monthly mortgage payment (principal & interest) would be $855.35.
BUY NOW: requires a $10,000 down payment for a total loan amount of $190,000. At an interest rate of 5.375%, the monthly mortgage payment (principal & interest) would be $1059.20.
No doubt $855.35 is better than $1059.20 for a monthly payment – that’s not what’s at stake here. The difference between those two payments is $203.85. In order for a person to save the additional $30,000 to go from a 5% down payment to a 20% down payment at the rate of $203.85/month, it would take over 147 months (12.25years!) to get to that point, which is almost half the life of a 30-year mortgage–and who knows what home prices will be like 12 years from now!
For many perspective buyers, that additional $204/monthis significant. We have a number of strategies to help make up that difference and get you into a home as soon as possible!
This is a reprint (with a few changes) from a few years back, but the message is still relevant today.
Lately, I have had a number of borrowers come to me specifically with the desire to purchase a home using a down-payment-assistance program. These programs take on many different looks, but the gist is basically the same: someone is willing to give a borrower a percentage of the purchase price of a home to be used as a down payment, and the obligation is forgiven when the borrower has lived in the home for a certain period of time.
A lot of these borrowers who come to me call it “free money” –and that always makes me pause for a moment before I remind them that nothing is free and that there are two major factors that accompany these programs that MUST be considered and always have a direct effect on the amount of money a buyer can borrow:
- When someone uses a down-payment-assistance program, the banks who are lending the money will increase the interest rate, usually, by about 1.5%. Obviously, the reason is the banks feel there’s more risk, so they require a little more from the borrower –and the other reason, let’s be honest, is the banks are legally allowed to charge that increased rate, so they do.
- The debt-to-income ratio, when compared to other options like an FHA loan, is significantly lower –this means that banks aren’t willing to lend as much money based on the borrower’s income.
After I explained this to a couple I recently met to discuss mortgage options, they asked me what this meant in “real” numbers, so I presented them with exactly that:
Based on their income, with the interest rate increase that the DPA program entails and the lower debt-to-income ratio, they would qualify for a mortgage of roughly $112,000. Conversely, with the same income, if they came up with the down payment themselves (3.5% of the purchase price), the interest rate would be lower, and the debt-to-income ratio allowed would be higher –this means that they would qualify for a mortgage of roughly $193,000. Before I could get that second number completely out of my mouth, one of the borrowers said, “That’s an $81,000 difference! Are you serious?”
While I assured the couple that I was serious, I then asked them which option they would prefer: buy a smaller house so they could get “free” money or look into ways they could put together the 3.5% needed to make the down payment themselves so they could afford a larger house and have more choice of houses. They decided to find the money to make the down payment themselves –the $81,000 cost of “free” was a lot more expensive than $6,755 (which is 3.5% of $193,000). Can’t argue with that!