One of the largest determiners of whether you should buy a home depends on how you will finance it. There are three ways you can finance a home, you can either pay for it outright in cash, you can borrow the money, or you can use a hybrid of the two. Because most people don’t have upwards of $200,000 lying around, and because most lending sources don’t cover the full amount of a home purchase, generally a hybrid approach between putting some money down and borrowing from a lending institution is used. That means the biggest question that needs to be answered is how much cash and how much debt should be used to finance your home?
If you read the post Should You Buy a Home then the answer to the question “how to finance should you finance your home?” should align with the same end goal, receiving the highest rate of return on your initial investment for the lowest risk possible.
Imagine that financing your home lies on a spectrum. On the far left of the spectrum, you have a 100% cash financed purchase, on the right of the spectrum, you have a 100% debt financed purchased. The closer you are to the left, the more you limit your total return but the lower your total risk. The closer you are to the right, the higher your potential total return but the higher your total risk.
With any type of investment, the larger the initial investment, the more difficult it is to earn a higher return. For example, if you buy an asset for $100 and it increases to $200 your total return in dollar figures is $100 and your total return in percentage figures is 100%. If you buy an asset for $1000 and it increases to $1,100, your total return in dollar figures is $100 the same as the previous example, but your total return in percentage figures is only 10%, one-tenth of the return in the previous example. This works the same for an investment in a home.
The down-payment you make in a home is the initial investment you are making in your home. The larger the down payment you make the lower your potential return, reciprocally, the lower the down payment you make, the higher your potential return. Intuitively, one would think that to receive the highest return possible, I should put the minimum amount down possible and finance the remainder. The problem with this strategy is that the less money you put down, the higher the probability of default from a potential lenders point of view. The riskier you are as a borrower, the higher the cost to borrow money. When the costs to borrow money, also known as the interest rate, is high, your total return in percentage term decreases.
For example, if you purchase a home for $300,000 by putting down $100,000 and borrowing $200,000 at an interest rate of 5.00% for an investment property that rents for $20,000 per year, your net profit per year will be:
[Rental Income – (Loan Amount * Annual Interest Rate)]
or
[$20,000 – ($200,000 * 5.00%)] = $10,000
This would give you a return on investment of $10,000/$100,000 = 10%
If you were to purchase that same home for only $10,000 down and borrowed the remaining $290,000 at an interest rate of 10% and received the same rental rate of $20,000 per year, your net profit would be:
[Rental Income – (Loan Amount * Annual Interest Rate)]
or
[$20,000 – ($290,000 * 6.75%)] = $425
This would give you a return on investment of $425/$10,000 = 4.25%
While this is an extreme example to exaggerate a point, the message here is that maximizing your return while minimizing your risk is a balancing act between the cash you put into the home (also known as equity) and the debt you layer on top of it (also known as leverage). Because it is near impossible to predict with a high degree of precision what the price of a home will be a few years from now, it is better to first begin with the costs associated with financing the purchase of a home.
There are three loan types that ASIS lending offers for refinance and purchase. They are an FHA (Federal Housing Administration) Loan, a Conventional Loan or a VA (Veteran Authority) Loan. Each loan type has guidelines and specifications that must be met to qualify for that loan type. Which one is best for you, depends on your current specific situation. Below is a breakdown of the requirements, pros and cons of each loan type.
