Before Making A 20% Mortgage Down Payment, Read This

Should you make a 20% mortgage down payment?

“How much should you put down on a house?”

It’s a common question among home buyers — especially first-timers. And, the answer will vary by buyer.

If you’re a home buyer with a lot of money saved up in the bank, for example, but you have relatively low annual income, making the biggest down payment possible can be sensible. This is because, with a large down payment, your loan size shrinks, reducing the size of your monthly payment.

Or, maybe your situation is reversed.

Maybe you may have a good household income but very little saved in the bank. In this instance, it may be best to use a low- or no-down-payment loan, while planning to cancel your mortgage insurance at some point in the future.

One thing is true for everyone, though — you shouldn’t think it’s “conservative” to make a large down payment on a home. Similarly, you shouldn’t think it’s “risky” to make a small down payment.

The opposite is true.

About the riskiest thing you can do when you’re buying a new home is to make the largest down payment you can. It’s conservative to borrow more, and we’ll talk about it below.

What is a down payment?

In real estate, a down payment is the amount of cash you put towards the purchase of home.

Down payments vary in size and are typically described in percentage terms as compared to the sale price of a home.

For example, if you’re buying a home for $400,000, you’re bringing $80,000 toward the purchase, your down payment is 20 percent.

Similarly, if you brought $12,000 cash to your closing, your down payment would be 3%.

The term “down payment” exists because very few people opt to pay for homes using cash. Their down payment is the difference between they buy and what they borrow.

However, you can’t just choose your down payment size at random.

Depending on the mortgage program for which you’re applying, there’s going to be a specified minimum down payment amount.

For today’s most widely-used purchase mortgage programs, down payment minimum requirements are:

  • FHA Loan: 3.5% down payment minimum
  • VA Loan: No down payment required
  • HomeReady™ Loan: 3% down minimum
  • Conventional Loan (with PMI): 3% minimum
  • Conventional Loan (without PMI): 20% minimum
  • USDA Loan: No down payment required
  • Jumbo Loan: 10% down

Remember, though, that these requirements are just the minimum. As a mortgage borrower, it’s your right to put down as much on a home as you like and, in some cases, it can make sense to put down more.

Purchasing a condo with conventional loan is one such scenario.

Mortgage rates for condos are approximately 12.5 basis points (0.125%) lower for loans where the loan-to-value (LTV) is 75% or less.

Putting twenty-five percent down on a condo, therefore, gets you access to lower interest rates so, if you’re putting down twenty percent, consider an additional five, too — you’ll get a lower mortgage rate.

Making a larger down payment can shrink your costs with FHA loans, too.

Under the new FHA mortgage insurance rules, when you use a 30-year fixed rate FHA mortgage and make a down payment of 3.5 percent, your FHA mortgage insurance premium (MIP) is 0.85% annually.

However, when you increase your down payment to 5 percent, FHA MIP drops to 0.80%.

It’s risky to make a large down payment

As a homeowner, it’s likely that your home will be the largest balance sheet asset. Your home may be worth more than all of your other investments combined, even.

In this way, your home is both a shelter and an investment and should be treated as such. And, once we view our home as an investment, it can guide the decisions we make about our money.

The riskiest decision we can make when purchasing a new home?

Making too big of a down payment.

A down payment will lower your rate of return

The first reason why conservative investors should monitor their down payment size is that the down payment will limit your home’s return on investment.

Consider a home which appreciates at the national average of near 5 percent.

Today, your home is worth $400,000. In a year, it’s worth $420,000. Regardless of your down payment, the home is worth twenty-thousand dollars more.

That down payment affected your rate of return.

  • With 20% down on the home — $80,000 –your rate of return is 25%
  • With 3% down on the home — $12,000 — your rate of return is 167%

That’s a huge difference.

However! We must also consider the higher mortgage rate plus mandatory private mortgage insurance which accompanies a conventional 97% LTV loan like this. Low-down-payment loans can cost more each month.

Assuming a 175 basis point (1.75%) bump from rate and PMI combined, then, and ignoring the homeowner’s tax-deductibility, we find that a low-down-payment homeowner pays an extra $6,780 per year to live in its home.

Not that it matters.

With three percent down, and making an adjustment for rate and PMI, the rate of return on a low-down-payment loan is still 105%.

The less you put down, then, the larger your potential return on investment.

Once you make your down payment, you can’t get those monies back (easily)

When you’re buying a home, there are other down payment considerations, too.

Namely, once you make a down payment, you can’t get access to those monies without an effort.

This is because, at the time of purchase, whatever down payment you make on the home gets converted immediately from cash into a different type of asset known as home equity.

Home equity is the monetary difference between what your home is worth on paper, and what is owed on it to the bank.

Unlike cash, home equity is an “illiquid asset”, which means that it can’t be readily accessed or spent.

All things equal, it’s better to hold liquid assets as an investor as compared to illiquid assets. In case of an emergency, you can use your liquid assets to relieve some of the pressure.

It’s among the reasons why conservative investors prefer making as small of a down payment as possible.

When you make a small down payment, you keep your cash position high, which leaves your portfolio liquid and accessible in the event of a catastrophe.

By contrast, when you make a large down payment, those monies get tied up with the bank. You can only access illiquid home equity via a home loan refinance, or a sale of your home — and both of those options cost money.

Furthermore, both methods take time.

If your household is in a pinch and you need to access your money now, a refinance requires 21 days at minimum to close but can take as long as 2 months to get finished. Selling your home can take even longer.

It’s nice to make a large down payment because it lowers your monthly payment — you can see that on a mortgage calculator — but when you make a large down payment at the expense of your own liquidity, you put yourself at risk.

Conservative investors know to keep their down payments small. It’s better to be liquid when “life happens” and having access to cash is at a premium.

You’re at risk when your home value drops

A third reason to consider a smaller down payment is the link between the economy and U.S. home prices.

In general, as the U.S. economy improves, home values rise. And, conversely, when the U.S. economy sags, home values sink.

Because of this link between the economy and home values, buyers who make a large down payment find themselves over-exposed to an economic downturn as compared to buyers whose down payments are small.

We can use a real-world example from last decade’s housing market downturn to highlight this type of connection.

Consider the purchase of a $400,000 home and two home buyers, each with different ideas about how to buy a home.

One buyer is determined to make a twenty percent down payment in order to avoid paying private mortgage insurance to their bank. The other buyer wants to stay as liquid as possible, choosing to use the FHA mortgage program, which allows for a down payment of just 3.5%

At the time of purchase, the first buyer takes $80,000 from the bank and converts it to illiquid home equity. The second buyer, using an FHA mortgage, puts $14,000 into the home.

Over the next two years, though, the economy takes a turn for the worse. Home values sink and, in some markets, values drop as much as twenty percent.

The buyers’ homes are now worth $320,000 and neither homeowner has a lick of home equity to its name.

However, there’s a big difference in their situations.

To the first buyer — the one who made the large down payment –$80,000 has evaporated into the housing market. That money is lost and cannot be recouped except through the housing market’s recovery.

To the second buyer, though, only $14,000 is gone. Yes, the home is “underwater” at this point, with more money owed on the home than what the home is worth, but that’s a risk that’s on the bank and not the borrower.

And, in the event of default, which homeowner do you think the bank would be more likely to foreclose upon?

It’s counter-intuitive, but the buyer who made a large down payment is less likely to get relief during a time of crisis and is more likely to face eviction.

Why is this true? Because when a homeowner has at least some equity, the bank’s losses are limited when the home is sold at foreclosure. The homeowner’s twenty percent home equity is already gone, after all, and the remaining losses can be absorbed by the bank.

Foreclosing on an underwater home, by contrast, can lead to great losses. All of the money lost is money lent or lost by the bank.

A conservative buyer will recognize, then, that investment risk increases with the size of down payment. The smaller the down payment, the smaller the risk.

Is it better to put a large down payment on a house?

A large down payment helps you afford more house with the same payment. In the example below, the buyer wants to spend no more than $1,000 a month for principal, interest, and mortgage insurance (when required).

Here’s how much house this homebuyer can purchase at a 4 percent mortgage rate. The home price varies with the amount the buyer puts down.

Down payment % DP dollar amount Principal & interest / PMI Home price
3% $4,635 $884/$116 $154,500
5% $8,775 $896/$104 $175,500
10% $19,310 $913/87 $193,000
20% $52,365 $1,000/$0 $261,500

Even though a large down payment can help you afford more, by no means should home buyers use their last dollar to stretch their down payment level.

And, as the charts below show, you don’t save a ton of money each month by putting a lot down.

Comparison of down payment and monthly payment per loan program (FHA, VA, USDA, Conv 97, 5% down, 10% down)

Making a $75,000 down payment on a $300,000 home, you only save $500 per month compared to a zero-down loan.

Increase liquidity with a home equity line of credit

For some home buyers, the thought of making a small down payment is a non-starter — regardless of whether it’s “conservative”; it’s too uncomfortable to put down any less.

Thankfully, there’s a way to put twenty percent down on a home and maintain a bit of liquidity. It’s via a product called the Home Equity Line of Credit (HELOC).

A Home Equity Line of Credit is a mortgage which functions similar to a credit card:

  • There is a credit line maximum
  • You only pay interest on what you borrow
  • You borrow at any time using a debit card or checks

Also similar to a credit card is that you can borrow up or pay down at any time — managing your credit is entirely up to you.

HELOCs are often used as a safety measure; for financial planning.

For example, homeowners making a twenty percent down payment on a home will put an equity line in place to use in case of emergencies. The HELOC doesn’t cost money until you’ve borrowed against it so, in effect, it’s a “free” liquidity tool for homeowners who want it.

To get a home equity line of credit, ask your mortgage lender for a quote. HELOCs are generally available for homeowners whose combined loan-to-value is 90% or less.

You can even use a piggyback loan, with no money borrowed on the second lien.

This means that a homeowner buying a $400,000 home can borrow 80% for a mortgage, then have another $40,000 available to use in emergencies via a HELOC.

Adding a home equity line of credit to your mortgage can help you stay liquid and protect against a crisis. Mortgage rates are often low.

What Are Today’s Mortgage Rates?

When you’re planning for a down payment, there are additional considerations beyond “how much can I afford to put down”. Consider your down payment in the context of your tolerance for investment risk, as well.

Get today’s live mortgage rates now. Your social security number is not required to get started, and all quotes come with access to your live mortgage credit scores.

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