Determining Your Mortgage Down Payment - Should You Use All Your Savings?

Once we've found our dream home, we face many financial decisions. One of the first: how much down payment comes out of our own pocket, and how much the bank tops up for us (this is the mortgage loan). The down payment is the money we "bring from home" to buy the property. It can come from money we saved each month, help from parents, selling securities, loans we took out, and so on.

• If we buy a home for one million NIS and raised 300,000 NIS from family, then our down payment is 30% and our LTV is 70%, or 700,000 NIS.
• If the home we bought is worth 2.2 million NIS and we have one million NIS, then our down payment is 45.5% and the LTV is roughly 54.5%.

The supervision of the banking system defined three LTV brackets. Each one sets how much capital the bank must set aside to grant us the mortgage. The higher our LTV, the more capital the bank has to set aside, and so the fewer customers it can lend to. That's why the LTV bracket determines the interest rates we get. If our LTV is below 45%, we get the best rates — because the bank has to set aside little capital to lend to us. If our LTV is above 60%, we get the highest rates. To get a sense of the differences, you can look at the current interest-rates page and break the rates down by LTV.

In other words, the size of the down payment we choose affects our LTV and our mortgage. The bigger the down payment, the shorter, cheaper, and safer the mortgage. So naturally we'd want to push the down payment up and the mortgage down as much as possible, right?

Now, John Doe sits down to get ready to take out his mortgage. After reading and digging through forums and soaking up the wisdom of the crowd on everything we just described, he arrives — in our opinion — at the following mistaken decision:

In our view, the public holds a somewhat simplistic notion about debt. The prevailing attitude is that you mustn't be in debt, that debt is bad, and that the mortgage should be paid off as early as possible. Everyone hates their mortgage (yes, us too) and acts irrationally to wipe it out. But we'd argue that reality is more nuanced and worth looking at from a different angle.

In our view, the mortgage is the best burden that will ever land on your shoulders. You have an opportunity (and a duty) to commit to a structured process of defining your household's financial goals and priorities. You can decide what matters to you in your career, in raising your family, and in your investments — and then plan the mortgage around those goals.

We'd like to stress that the issues here also apply when you're weighing whether to use future funds (for example, redeeming a study fund ("Keren Hishtalmut") or an inheritance) to reduce the mortgage loan.

Don't let the mortgage wipe out our dreams

In a needs-assessment conversation — the first stage of the mortgage advisory process — we try to understand what financial goals we want to reach. What are our dreams? Where do we see ourselves down the road? Are we working a job that's good for us?

These are some of our clients' dreams:

• "I want to start a startup"
• "I want to stop being chained to my store — train a manager to take my place and branch out into other areas of business"
• "We want to take big, meaningful trips with our kids"
• "I want to buy an investment property"
• "I want to have plastic surgery"
• "We want to adopt a child"

Realizing these dreams takes capital — the very capital you earmarked for those dreams before you bought the home, and that you're now thinking of sacrificing on the altar of a smaller mortgage. This is the capital that can fund:

• A year of unpaid work on a new venture.
• Hiring a new employee who pushes your business a step forward.
• The down payment on a new financial investment.

Yes, if you use this capital to reduce the mortgage, you'll owe the bank less. But your ability to pursue your goals will take a serious hit.

So before you decide to lock this capital into the walls of the house, remember your dreams and aspirations. We'd happily bet that a cheap mortgage was never one of them. Life is too short; we don't live to pay off debt, we live for meaning and enjoyment.
So yes, your mortgage may be 100,000 NIS more expensive or three years longer — but you'll have the chance to build the life you wanted for yourself and your loved ones.

Don't let the mortgage wipe out our assets

We take an accountant's approach when we plan our clients' mortgages. At every point, we look at our net economic value.

If I have assets worth 200,000 NIS (shares, deposits, properties, provident funds, etc.) and liabilities of one million NIS (loans, standing orders, a mortgage), then my net economic value is 200,000 NIS minus one million NIS, or minus 800,000 NIS.

If we use these assets to reduce the outstanding mortgage principal, our total assets drop to zero and the mortgage principal drops to 800,000 NIS. Notice that our net economic value is still minus 800,000 NIS. It didn't change — but we lost liquidity.

So why make an early prepayment at all? What's more, if instead of reducing the mortgage principal we invest these assets in income-producing channels, we come out ahead. Remember — in investments, our assets grow with compound interest. And on the other side, our liabilities shrink (because we're paying down the loan and repaying the principal).

The critics will say we're wrong, and that the gain actually lies in reducing the mortgage. True, we lost liquidity but we cut our debt. On top of that, the skeptics will say, the debt we paid off has a guaranteed cost (because the bank charges us interest on the principal), whereas our assets have uncertain profit and return, since no investment can promise a return.

As evidence, the critics will pull out the S&P 500's performance over a single year. The chart below shows the return we'd have gotten had we bought the S&P 500 index and held it for one full year, by the year we made the investment. You can see and recall, for example, that 2008 was a very bad year to invest in the stock market. Had we bought the S&P 500 for 100 NIS at the start of 2008 and sold at the end of it, our money would have lost 37% of its value. Ouch.

What is myopic loss aversion?

Looking at the chart, you can indeed spot many years with negative performance. There are also years in which the S&P 500's return is lower than the expected mortgage interest rate. In fact, over the last 39 years, 20% of them ended with a negative return or one too small to be worth it. So why take the risk at all? Come on, let's put the whole down payment into the mortgage!

This is called "myopic loss aversion." We fixate on the short-term risks and losses and ignore the benefits and gains we'd get from taking those risks. It costs us money — a lot of it. If we change the way we look at things, we'll see a completely different picture and most likely change our behavior too.

The law of large numbers - the reason to stay in the capital market over time

If you're still not convinced, brace yourself for a bit of math. The law of large numbers proves that a multi-year investment will bring the average annual return to its expected value with a probability of one. That is, if those same 200,000 NIS are invested in the S&P 500 at an annual return of 6.6%, then after many years the average annual return of our investment converges very close to 6.6%. So, for example, if we buy S&P 500 securities and hold them for five years straight, the average annual return will be:

Each year in this chart shows the average annual return we'd have gotten had we invested in the S&P 500 over the five years leading up to that year. Note — consistency pays off! For example, someone who bought the S&P 500 in 1996 and sold at the end of 2001 earned a little over 10% a year on their investment. Thanks to long-term investing, we managed to smooth out the downturns considerably. What happens if we buy S&P 500 securities and hold them for fifteen years? You can see how dramatically the picture improves.

Just to make sure it's clear: had we invested in the S&P 500 between 2000 and 2015, the average annual return on our investment would have been 3.1% per year.

In fact, over the last twenty-five years, there isn't a single year in which investing in the index and holding it for 15 years would have produced a negative return. In our view, looking at savings over a span of many years shows us how we should act — the money we save each month compounds and grows, alongside a mortgage debt that keeps shrinking on its own.

So our suggestion is to consider the following idea (note: this is not investment advice):

Minimum down payment for a home - should you leverage the mortgage funds to the maximum?

Let's get ahead of this one. It's a question our clients ask all the time: why not take 75% financing from the bank (that is, maximum financing) and invest the money?

We can't say categorically that it's right or wrong. The leverage decision varies from person to person and from household to household. The critical questions are your return on alternative investment and your risk tolerance.

If your investments don't bear fruit, or the return is lower than the interest on the mortgage, then there's no justification for investing the money. On top of that, taking more financing than you actually need leads to one of two things:

a. A longer mortgage. This exposes us to risks unrelated to the mortgage itself. What if we fall ill? What if we get laid off? What if we divorce or separate? As time passes, the odds of an event that upends our lives keep rising. The advice is to hedge the risk — finish with the mortgage.

b. A bigger mortgage means a bigger monthly payment. Loans have to be paid, and this debt has to be repaid every single month. A jump that large in the monthly payment can hurt our quality of life. The advice is to check that your monthly cash flow can handle it.

So how much down payment do you need for a mortgage?

So our conclusion is simple. As with everything in life, don't go to extremes. That's the essence of mortgage planning — hedging risk. The advice is to plan the down payment and the monthly payment so that you can both invest money on the side and pay down the mortgage quickly.

Want to see how the size of the down payment affects the monthly payment and the cost of the mortgage? Head to the mortgage calculator and see for yourself.

Good luck!