Interest rate vs downpayment conundrum?

Question

Hi all! First time poster here, really love all the super helpful advice in this forum that I've seen so far. Was hoping you guys might be able to help me think through the following situation.

We are looking at purchasing a home that's about $1.75 million total purchase price (bay area).

Bank 1 has offered us (through a special relationship with my employer) a rate of 3.875% for 30-year fixed mortgage, but only requires 10% down payment with no PMI requirement.

Bank 2 has offered us a rate of 3.125% for 30-year fixed mortgage, but requires 20% down payment, and the 3.125% low rate is conditioned upon us putting $500k cash in a Bank 2 account (I think this $500k would include the down payment amount and isn't on top of/additional to the down payment, thankfully!). If I didn't put the $500k cash in a Bank 2 account, the rate would be 3.375% instead.

I'm trying to figure out which option makes more sense in the long run overall (setting aside fairly obvious generalizations like "with option 1, your monthly payments would be higher than in option 2").

Assume that we would put any difference in funds saved between the Bank 1 and Bank 2 scenarios in, say, an S&P 500 index fund.Any thoughts would be greatly appreciated and please let me know if I need to clarify my question in any way!

Jonathan R McLaughlin · Answer

If you do the 10% downpayment what are you going to do with the 140K you save? If you have allocated a set amount to real estate, that amount would be enough to add substantial value to either the single or the duplex (maybe your ADU) after which you could refi and your overall cost structure be better. And look at the fine print on the loans, a point or so is a fair amount of money over 1M. You aren't counting pennies, but still.Not sure index funds are a "set it and forget it" investment right now either. Bottom line you've got great choices and no bad options.

Angela Chen · Answer

@Amit M. @Brian Garlington Thanks, guys! We're actually looking at both single family and duplex residential units. The duplex of course has 2 units, and Brian's question about the SFR is very on point, because we are currently debating how hard it would be to add an attached ADU, or bump out the house that we're looking at at the moment. Seems like that might be a bit challenging seeing as the house was built on concrete slab (so, my extremely limited understanding is that it might be a much more costly endeavor to build out an additional kitchen/bathroom because of plumbing issues, for example?)Edit: I should emphasize that I really don't know very much about construction so maybe it's actually less of a big deal than I thought in terms of the house being on a concrete slab vs having crawlspace, when it comes to additions/plumbing? Anyway if anyone has thoughts on this point too, do let me know, although I realize that that's veering off the original topic of this post somewhat so feel free to ignore this part if not appropriate!

Brian Garlington · Answer

I was literally thinking the same thing Amit M. mentioned. You may not want to sell it in a few years.......pull cash out of it to buy another property, and keep it as a rental. Maybe I missed it somewhere, but what type of property is it? Multifamily? SFR? If it's an SFR does it have an In Law Unit?

Amit M. · Answer

@Angela Chen if you think you will be staying in the Bay Area long term, you may also want to keep that home as a rental, after you move into your next/forever home. A lot of people in the Bay Area have made a ton of money leveraging the appreciation on 2 homes over the years. In that case, having the low rate is a long term advantage. I’m not convinced we will be seeing low rates like these once we eventually pull out of this recession. The country has borrowed a ton of money, and I think there will be inflationary pressure in the coming years. People that are set with these crazy low rates will look like geniuses 5+ years from now...IF that inflationary scenario plays out. And if not, you still have a low rate for your current needs. The 500k is not an issue if you can do whatever you want with it after closing.

Angela Chen · Answer

Thanks, @Arlen Chou!

Arlen Chou · Answer

@Angela Chen IF you are able to pull the $500k out at any point after you close on the deal, and you can afford to tie up cash for a few months. I would lock in the lower rate. The rate of 3.125% is basically a set and forget rate. You would need to be below 2.75% to really make any sense for a refi. The only real reason to go with the 3.875% is if you can only get 10% down or you expect to need the cash in the immediate future.Good luck to you in whichever direction you go!

Angela Chen · Answer

By the way, in case it changes anything - apparently it's perfectly permissible to pull out the $500k from Bank 2 as soon as the transaction has closed. Not sure if that changes anything?

Angela Chen · Answer

Thank you so much, @John Warren! That's a very good point. I think we were planning to hold onto the property for at least 8-10 years if not longer, but you're right that it's unlikely to be the entire 30 years. On the refinancing question, not sure whether we would end up refinancing since interest rates are so low at the moment (though never say never, it might be lower at some point in the future...)

John Warren · Answer

@Angela Chen think through how long you will actually hold the property. A shocking amount of property owners in general trade their loans in every few years. Obviously, the interest rate makes a big difference at this level, but if you are going to sell the property in a few years or if you are going to refinance at some point then it may not matter as much. I know I personally have refinanced every single loan I have used for investing over my six year career to get cash out, so the long term fixed 30 year rate has been pretty much irrelevant.