The Cost of Free

 

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:

1. 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.
2. 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!