Recently, one of our client families came to us with questions around how best to finance a down payment for their future home. A young couple, their home was perfect back when it was just the two of them. But several years and a couple of kiddos later, they feel they’re outgrowing it. Rather than sell, they were considering keeping their current home as a rental. This put them in a predicament: how could they finance a down payment on their new home without the liquid equity that would come from selling their current home? They currently have about 10% saved up in the bank. During our meeting, we compared the two main options they were considering:
Option 1: Use existing 10% savings as the down payment.
Pros:
- Less paperwork. They would not have to utilize other resources or go through any application process. They simply cut a check from their bank.
Cons:
- Higher interest rate. Generally speaking, the lower the initial equity in the home, the higher the interest rate will be. In their case, they were looking at about a 0.50% difference between putting 10% down vs. 20% down.
- They would incur mortgage insurance. In researching their options, I called a local lender to talk in generalities and get a sense of what this meant for them. He estimated they’d pay about $1,300/year, which disappears after the equity in the home reaches 20% (about 6 years in this case).
- They may not be competitive buyers. Homes are moving relatively quickly at the moment, particularly in the area they were looking and the type of home they were looking for. The days of a sappy letter getting you on the good side of sellers seem to be all but gone. Flipping homes has become very popular and now, buyers are bringing more cash to the table to gain a competitive edge. 10% down may not have been enough to make their offer stand out.
Option 2: Pull from Roth IRA’s to gather up a 20% down payment.
Pros:
- They would avoid mortgage insurance. Over the life of the loan, mortgage insurance would total $7,800.
Cons:
- They would miss out sorely on the magic of compounding interest. To get up to 20% cash, the couple would have had to withdrawal $50,000 from their retirement accounts. While it’s a little known fact that regardless of your age, contributions can be withdrawn from Roth IRA’s without tax or penalty, that did not make this idea any more attractive. I ran a side by side comparison of their accounts with and without that $50,000. Over the 30-year life of the loan, a withdrawal of $50,000 today would have meant missing out on over $330,000 in growth. That’s the power of compounding interest!
This family has done so much right in their short time as savers. Painting a picture of just how detrimental tapping their retirement accounts could be helped them to make a better choice. I brought a couple of other options to their attention:
Option 3: Continue to save until 20% threshold has been reached.
Pros:
- Lower mortgage interest
- No mortgage insurance.
- Higher immediate equity.
Cons:
- They would need to put their home search on hold.
Option 4: Take out a HELOC.
Pros:
- Utilizes existing home equity without depleting the 10% nest egg
- Positions them more favorably with buyers.
Cons:
- Paperwork.
- Increases their liabilities in the short term
- Annual fees and variable interest rates associated with the HELOC.
- According to the latest interpretation of the Tax Cuts and Jobs Act, interest on the HELOC would not be deductible in this circumstance.
In the end, our clients chose to hold off on the purchase of a new home and invest some of their cash into remodeling their current home. This achieves several of their goals. 1) It updates their current home to better suit their family’s needs. 2) It increases the attractiveness of the home as a rental, or sale if they choose to go that route. 3) It gives them time to further consider other options that lie ahead without feeling like they’re living uncomfortably. We welcome opportunities like this to help our clients make smart decisions that balance the needs and wants of today with the goals and dreams of tomorrow.
