Reader Question: Down Payment or Car Savings?

by Kevin on August 26, 2009

I’ve had a few people already drop me an e-mail with questions to be answered on this blog. I’m still looking for more questions!

As a reminder: only provide the facts, and I will do everything I can to make sure your question is anonymous. (Meaning I won’t do anything weird like post your name, e-mail address, etc.) Of course I offer no guarantee. If you write a long question about your husband and he happens to read my blog and figure it out, you’re on your own.

A reader e-mailed in with the following question.

Should We Save for a Car or Put Additional Money Toward Our Down Payment?

“We are in the process of buying our first house and trying to come up with a good number for a down payment. We can easily meet the 5% DP for our FHA loan, but at the same time aren’t close to having 20% to avoid PMI.

Basically we have about $8,000 up in the air (~3% of the value of the house) that we are trying to decide if we should add to the down payment or to use to kick start our car savings to avoid the need to take a car loan when that time comes.

We have two cars in our household, one with ~120k miles and another with ~98k miles. We’re currently debt-free with ~6 months emergency fund in place. What’s the smart move?”

First, thanks for my first reader question in a long time. I hope my answer helps you out. I’ll admit it is a bit long, but bear with me because the devil is in the details.

As with any question there are many additional questions I could ask to clarify before answering. But that would get redundant so I will use some assumptions to help guide my answer.

Assumptions:

  • Home Value: $270,000 (if $8,000 is 3%, then divide $8,000 by 0.03 and you get $266,666. I’m rounding up for simplicity.)
  • Down payment (5%): $13,500
  • PMI: $120 (CNN says the average PMI is $50-80 per month on an average home price of $159,000… I am just guessing here)
  • Mortgage rate: 5.33% (today’s average 30-year mortgage rate according to Bankrate.com)

Save Money for Future Car Purchase

If the reader decides to keep the money in reserve for a future car purchase, this is how the mortgage payments would play out.

  • Mortgage amount: $256,500 ($270,000 minus $13,500 down payment)
  • Mortgage principal and interest payment (no taxes or insurance taken into consideration): $1,429.14
  • Total payment (principle, interest, PMI, no tax, no insurance): $1,549.14
  • Total interest over the life of the loan assuming no prepayment: $257,989.24

Apply Money to Down Payment and Lower Mortgage Amount

If the reader instead decides to apply that $8,000 toward the mortgage, this is how the mortgage payments play out:

  • Mortgage amount: $248,500 ($270,000 minus $21,500 down payment)
  • Mortgage principal and interest payment (no taxes or insurance taken into consideration): $1,384.57
  • Total payment (principle, interest, PMI, no tax, no insurance): $1,504.57
  • Total interest over the life of the loan assuming no prepayment: $249,940.97

What I Would Do If I Were In Your Shoes

If I had to make the decision I would keep the money in savings in anticipation of needing to replace a car in the future. Here’s why.

3% Extra Down Payment Really Isn’t That Much

The difference in putting the money down on the mortgage and keeping it for other purposes comes to only $8,048.27 in interest.

Additionally the difference in the payment is only $44.57. If you applied the money to the down payment and were disciplined enough to save that additional $44.57 each month (in essence, paying yourself back) you would earn your money back in 179.5 months. That is 15 years.

Other factors come into play such as how quickly you would get to 20% so you could ditch PMI. If the home value stayed the same at $270,000 then you need to reach $54,000 in total equity to rid yourself of PMI. (Or you could phrase it that you need to have $40,500 in equity from your mortgage payments — $54,000 minus the down payment).

If you applied the money toward the down payment  you reach $54,000 in October 2018. Approximately 9 years from now. From that point you could apply that $120 PMI payment toward other goals or use it to pay down the mortgage even faster.

If you kept the money for other purposes you would reach 20% equity in December 2019 — a little more than 10 years from now.

The difference? 14 months of $120 PMI payments.

Note that I haven’t even gotten to the part about car expenses! At this point you are looking at 15 years before earning your money back, and the possibility of saving 14 months of $120 payments a decade from now.

My point being that a lot can change in a decade. And to deal with those changes I would rather have the money in the bank.

A Definite Car Expense On the Horizon

Additionally you have two aging cars. Of course I don’t know the condition of your vehicles. They could last to 150,000 or 200,000 miles if you take good care of them. And of course I would recommend you drive the cars as long as you can. Try to pay cash for the next set of cars. (We’re doing this and it is awesome knowing we have a car “payment” to ourselves.)

Then again one of your cars could die on your tomorrow. If you literally have $0 saved for the next car you would be forced to take on some sort of payment for your next vehicle even if it was an older used car.

But if you had $8,000 sitting in the bank you could, at the very least, buy a decent used car that would retain its value for at least twelve months, continue to save up money, sell the car and then buy a car that better fits your needs. All without an additional payment.

Another Perspective

A different way to look at this would be could you buy a car on payments — because you used all your extra cash on the mortgage — from the money you would save from the difference in the mortgage payment?

At $44.57 savings per month I think it is highly unlikely you could buy a car with the money you saved (about $2,700 over the first five years).

Note: If this question was about putting a full 20% down or putting just 5% down my decision changes pretty quickly.

Here’s why: your mortgage payment would be $1,158.91 — a full $390.23 less than if you put only 5% down. ($120 of that $390 is the lack of PMI.)

That $390 could buy you a nice car on payments if you had to resort to that option.

Bottom line: The $8,000 can buy you a lot of difference in vehicles, but not in mortgages.

Steps from Here

Whatever decision the reader makes I would recommend running through the steps of my No Debt Plan. Have goals, use a budget, cut expenses or grow your income to the point that you have free cash flow, pay down debt, save for the future, etc.

If I decided to save the $8,000 to kick start my car savings I would implement a plan and have a goal in mind of how much money I wanted to have saved up by the time the car died. I wouldn’t just stop at setting the $8,000 aside — I would plan all the way through at least the purchase of the first new vehicle.

In fact to make sure I didn’t spend the money on other tempting new home items (upgrading furniture, buying high end appliances, etc.) I would drop the money into an Ally Bank CD. They have some amazing rates and you can lock up your money for as little as 3 months or as long as 5 years. Whatever CD length you select you’ll be earning a higher rate of return than you would with your average online savings account – and every little bit counts when you are saving up for your next big goal.

I hope that helps. Good luck!

{ 6 comments }

Norma Jean August 26, 2009 at 12:47 pm

I really liked your analysis of this question. 15 years to recoup the money invested in the house downpayment, sheesh! The car payment seems the better choice in this case.

Kevin August 26, 2009 at 8:59 pm

Thanks for stopping by. If you’ve got a question you want answered, just let me know. I love “running the numbers”!

frugalgrad August 26, 2009 at 1:12 pm

I have to learn to analyze financial situation like this. I have taken the economic courses but still don’t learn any practical tips to help me in real financial situation. What a wast of money for those requirement courses.

PS: hope you get over 1000 followers soon!

vivian

frugalgrad August 26, 2009 at 1:20 pm

Also, just want to let you know that your Ally Bank CD link doesn’t work. Just a friendly reminder if you have some free time.

Kevin August 26, 2009 at 8:59 pm

Fixed! Thanks a ton!

Dee August 26, 2009 at 11:55 pm

This was a nice, thorough analysis.

Also, if for some reason one of the cars died sooner than expected (before they could re-save the money if they chose to put what they have toward the mortgage) they would be in a tough spot when trying to buy a new car. From what I’ve heard from car dealers, it’s tough to get financing when you have little to no money down.

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