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The Down-Payment Dilemma

Dear Dayana -- We are trying to decide how much we should commit for a down payment on our new house. We are looking at a home that would require $70,000 for a 20% down payment. We have $150,000 in savings and hope to realize $150,000 from the sale of our current home. We can afford the monthly mortgage payments without paying beyond the 20% down. How should we think about the allocation of our money for investing? -- Peter and Sheila

Hi Peter and Sheila,

Great question. Funny, it's not one we would have asked a decade ago, is it? Back then, mortgage interest rates were higher and the stock market pretty handily beat the real estate market over the long term. But times have changed, and you're right to ask this very important asset-allocation question.

Putting 20% down is a no-brainer, particularly since doing so will enable you to get out of paying private mortgage insurance (PMI). These days, your mortgage is some of the cheapest money you will ever borrow -- a low interest rate you can lock in for several decades at a time. Beyond that, the question of how to best deploy your resources gets a little more complicated.

Paying off the house is as much a psychological decision as it is an asset-allocation one. For some, the peace of mind that comes with knowing one's shelter is paid for is worth much more than the nebulous prospect of getting better returns in other types of investments.

If you want to do a true apples-to-apples, unemotional comparison, look at your home as just another asset, like your stocks, mutual funds, short-term savings, and retirement accounts. It's an interesting exercise and one that should be done by anyone who's "playing" the real estate market.

Recently on our discussion boards one poster did just that, likening one's residence to an income-producing asset. When paid for, you own an asset that pays out what you would otherwise pay to rent a comparable home. Buying homes to rent out is all the rage. But there's a Catch-22 to that strategy, particularly in places where the rental market is flagging.

Like traditional income-producing assets (such as stocks that pay dividends or interest-bearing vehicles), homes have the potential to go up in value. (Perhaps you've read a few articles about this trend lately.) Historically, homes have appreciated at about the rate of inflation. But this ain't your father's real estate market. According to the National Association of Realtors, the median home price in June was $219,000 -- up nearly 15% from June 2004. In the West, prices increased 17.4%, and in the Midwest and the Northeast, prices rose around 13%.

It's no secret that some people think that the frenzy is going to fizzle. We've talked about it here, with some Fools saying that you shouldn't bet on real estate. I recently told readers, "Don't sell your home!" But that advice was meant to caution potential prospectors against going from a current affordable housing situation to one where they'd have to stretch -- and potentially snap -- the budget.

When reviewing your assets, remember to factor in maintenance costs as well as the time you spend maintaining the asset. With traditional investments, you have brokerage fees, for example. And don't forget taxes. The government essentially helps subsidize your home investment in the way of tax breaks.

You also need to look at the costs of liquidating the asset should you need to free up some cash. Funds you pour into your mortgage are not as easily accessed as, say, stocks. Selling your home is one option. (Ah, resale, sweet resale. There's an art to finding the upgrades that will really pay off.) Yes, you can borrow against your home. But home equity loans often require a balloon payment. And if you need the money for an undetermined period of time, that kind of loan can be stifling. But for short-term cash needs, a home equity loan isn't necessarily a disastrous financial move.

I wish there were a simple, straightforward answer to your question. It'd certainly make answering email a lot easier. As you're mulling this over, here are a few more things to ponder when making this -- or any -- asset-allocation decision:

1. How do the rest of your finances look? Do you have short-, medium-, and long-term savings? Any major life changes on the horizon (kids, college, job change, retirement, pro-surfer school)?

2. Do you have high-interest debt (double digits) or other debts on depreciating assets (like car loans) that you could clear with your available funds? It might be nice to wipe the slate clean. Student loans are typically considered "good debt," but again, if you have the chance to take the IOU down to $0, that might be a good use of funds.

3. Would having a smaller monthly mortgage payment or more ownership in your home give you peace of mind, even if that money is "growing" at a slower rate than it might if it were deployed elsewhere?

4. How have your other investments done? Are you beating the market? Besting the appreciation on your real estate? With any investment there's the potential for losses. Even a checking account that you don't touch for 20 years loses value because the paltry interest rate doesn't allow your cash to keep up with inflation. The more you know about the investment -- the potential ups, downs, and different ways to play it (say, by investing in builders like Toll Brothers (NYSE: TOL  ) or home-improvement havens like Lowe's (NYSE: LOW  ) or Home Depot (NYSE: HD  ) -- the likelier you'll be to make a solid financial decision.

I'm sure these are questions you've asked yourself, but sometimes it makes sense to really play out different scenarios for a gut-reaction check.

The housing vs. stocks debate will go on for generations to come, no doubt. But when it comes to making a personal decision about how to best deploy one's assets, turn down the squawk box and fine-tune your big picture financial plan.

Dayana Yochim got into real estate in what can only be described as the mother of all impulse purchases. She owns none of the companies mentioned in this article but is on a first-name basis with the cashiers at Lowe's. The Fool's disclosure policy has been upgraded with wall-to-wall shag.


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