Mortgage
rates are at their lowest levels in years. Now is an excellent opportunity for
many people buying homes to lock in a low interest rate. Homebuyers can do a few
things to maximize their dollars and get the most for their money.
To
start, a homebuyer should make a down payment of 20% or more of the price of the
home to avoid Private Mortgage Insurance (PMI). PMI is insurance that protects
the lender against a buyer's default and can cost up to 1% of the cost of your
loan, annually. Homebuyers unable to put down 20% or more should verify with their
lender that the PMI will drop off once a 20% equity position is obtained.
Secondly,
homebuyers who have a large amount of savings for a down payment must decide whether
or not to make a down payment in excess of 20%. In this case, a comparison should
be made of the effective (actual) borrowing rate and the rate of return on an
investment portfolio.
The stated interest
rate on a mortgage is not always the effective borrowing rate because the interest
paid on a mortgage is generally a tax-deductible expense. Homebuyers can calculate
an effective borrowing rate by considering their federal and state marginal tax
rates. Keep in mind that itemized deductions are reduced when Adjusted Gross Income
(AGI) is over $150,000 (in 2006). In this case, a C.P.A. would need to calculate
the effective borrowing rate. The following example illustrates how to calculate
the effective borrowing rate, if the homebuyer's AGI does not exceed the annually
adjustable limit.
For
example:
Mortgage
Rate | Federal Tax
Rate | GA Tax Rate |
6.12% | 28% | 6% |
Calculation:
Federal
Tax Rate | + | GA
Tax Rate | = | Total
Tax Rate |
.28 | + | .06 | = | .34 |
(
1.00 - Total Tax Rate) | x | Mortgage
Rate | = | Effective
Borrowing Rate |
(
1.00 - .34 ) | x | .0612 | = | .0404
or 4.04% |
The
effective borrowing rate should be compared to the projected return on a portfolio.
This is based on the homebuyer's investment risk tolerance. If the expected return
of the portfolio is greater than the effective borrowing rate, the homebuyer may
want to limit the down payment to 20% of the price of the home and invest the
additional funds. Consider that historically the stock market has an annualized
return of 12%. If we assume taxes lower the after-tax return to 9%, it still makes
sense for our homebuyer to make a 20% down payment and to invest remaining savings
in the stock market.
Projected
After-Tax Return | - | Effective
Borrowing Rate | = | Difference
in Returns |
9% | - | 4.04% | = | 4.96% |
One
exception: If the homeowner finds it difficult to resist spending the cash rather
than investing, a larger down payment may be preferred.
