Mortgage Q&A: How much to borrow?

Q. I am under contract to purchase a new home being constructed in Maryland. I have been approved for 90 percent financing on a purchase price of $350,000. After I received the Good Faith Estimate from my lender, I realized my interest rate was significantly higher with a 10 percent down payment as compared to a 20 percent down payment.

I have more than $500,000 in my company’s 401(k) retirement account. My investment counselor suggested I take a 10 percent penalty and withdraw an additional $35,000 so I can increase my down payment to 20 percent and receive a lower rate and monthly payment.

Other people with whom I’ve spoken say I should take the 90 percent loan because the higher interest rate is tax-deductible. Plus, I wouldn’t have to pay a penalty for taking money out of my retirement account.

I can afford the payment on the 90 percent loan, but it’s uncomfortably high. What’s your opinion?

A. I agree with your investment counselor. While paying a 10 percent penalty of $3,500 to withdraw $35,000 is indeed expensive, there are some good arguments that suggest it makes sense.

First, I think financial decisions shouldn’t be made solely on the basis of number crunching. There are nonfinancial factors that should be considered.

In your case, the mere fact that you say the payment on the 90 percent loan would be “uncomfortable” is enough reason to consider an alternative. Assuming you plan on living in the home for a long time. The last thing you want to do is struggle making an “uncomfortable” payment. This could negatively affect other financial decisions, such as saving for a child’s education.

Second, it’s very possible the $3,500 penalty would be recouped very quickly because of the lower rate on the 80 percent loan. I don’t know the specific numbers, but if we assume the 90 percent loan carries an interest rate that’s 0.50 percent higher than the 80 percent loan, you would be saving roughly $1,500 in interest annually for every $300,000 borrowed. You would recoup the cost of the penalty in less than three years.

Third, I think any financial picture should be balanced. Having $500,000 in retirement funds and very little liquid cash and home equity seems to be a bit out of balance. While your retirement account demonstrates admirable savings discipline, it probably makes sense to take out $35,000 in order to start out with 20 percent equity in your new home and lower your mortgage costs and monthly payment.

While mortgage interest is indeed tax-deductible in most cases, please tell your friends who make this point that it doesn’t make sense to pay a higher interest rate just because the interest paid is tax-deductible. It just makes the interest cost less expensive.

I’ve had folks tell me they like paying a high interest rate on a mortgage because they are able to write off the interest. That simply makes no sense. I illustrate by using a fictitious example: If the cost of a loaf of bread is tax-deductible, that doesn’t mean you should buy the most expensive loaf when less expensive identical ones are available. The tax deduction just makes the expensive loaf less expensive.

Hats off to your investment counselor. I agree with that advice.

Henry Savage is president of PMC Mortgage in Alexandria, Va. Reach him at henrysavage@pmcmortgage.com.