So many of the financial problems people face (and the country too) is the buy now, pay later mindset. That means financing most or all of major purchases. In fact, the dominant obsession now is 100% financing – on cars, recreational vehicles and even houses. It’s all about putting the least down and financing the rest. This can create long-term problems when buying a house. And that’s why you should make a minimum down payment of 20% on a house.
This is an important topic to take on, since both the financial markets and the economy are looking a lot less stable than they did just a few months ago. The homeowner experience of the post-financial meltdown period shouldn’t be forgotten or ignored. So much of the personal horror stories of that time could have been prevented by better money management, including making more than the minimum down payment on a house.
But apart from the economy and the financial markets, there are compelling reasons for making a higher down payment – even if you’re able to get by with the minimum.
Eliminate Private Mortgage Insurance
As an example, let’s say that you are making a down payment of 5% on a house that will result in a $200,000 mortgage. With a credit score of 700, the private mortgage insurance (PMI) rate factor will be 0.89%, or 89% of 1% of the loan amount per year.
That will result in a monthly PMI premium of $148.33 ($200,000 X .01 X 0.89 = $1,780 divided by 12 months). That’s on top of your regular monthly principal and interest, real estate taxes, and homeowners insurance.
You will pay the premium – in slightly declining amounts – at least until the mortgage is paid down to where it equals 78% of the original purchase price. And that can take a decade or so to happen. In that timeframe, you will be paying an extra $15,000 or so for the private mortgage insurance – on top of the purchase price and closing costs on the home.
Home buyers often work around the PMI requirement by using a combination of an 80% first mortgage, with a 15% second mortgage, or home equity line of credit (HELOC).
But the first/second combo idea still requires that you make monthly payments on the second mortgage or HELOC. And it still keeps your equity in the property at 5%, which will not help with most of the other issues that are involved with minimum down payment house purchases.
Better Interest Rate + Lower Mortgage Payment
Generally speaking, the larger the down payment that you make on the purchase, the better your interest rate will be on the loan. In addition, the smaller mortgage obviously translates into a smaller monthly payment.
For example – ignoring PMI for the moment – let’s say that you’re purchasing a $200,000 property with a 5% down payment. That will result in a 95% loan, or $190,000. With a rate of 4.00%, your monthly payment on a 30 year mortgage will be $907.59.
But let’s say that you make a 20% down payment, resulting in an 80% loan for $160,000. With a rate of 3.875% (slightly better due to the larger down payment), your monthly payment on a 30 year mortgage will be $752.38.
That’s a savings of $155.21 per month. Now add in the $148.33 per month that you won’t be paying for PMI, and you’ll save $303.54 per month with a 20% down payment rather than a 5% down payment. That’s more than $3,600 per year, or $36,000 over a decade.
In addition, any closing costs that are calculated based on the amount of your mortgage will be lower with a 20% downpayment than with a 5% down payment.
More Equity for a Refinance
Up until about 2007 refinancing a mortgage was usually an easy process. Steady price appreciation with residential real estate meant rising equity. Not only was it easy to refinance the original loan balance, but there was often sufficient new equity to accomplish cherished cash-out refinance.
But that cozy arrangement is no longer so certain. In the aftermath of the 2008-2009 Financial Meltdown, house prices went into a multiyear decline in most of the country. The recent rebound in prices are only now beginning to bring values back to where they were in 2007. Meanwhile the lending community remains aware that house prices can go down as well as up, and are lending more conservatively.
If you make a minimum down payment on a house, and the value of the property is flat or declining, you could be trapped in your mortgage. A lack of equity, or sufficient equity, has been a major obstacle to successful refinancing since 2008.
Making a minimum down payment of 20% on a house will provide you with a lot more equity in a refinance than a minimum down payment will.
More Equity When Selling the Property
People don’t typically consider that there be a time when they will need to sell the house they are now buying, at least not anytime soon. But in the real world, circumstances can change without warning, forcing an unscheduled property sale.
It might come about because of a job transfer to another state, or because of personal financial difficulties, or because of a radical change in your household makeup. Whatever the reason, it rarely affords you much time to overcome financial constraints.
If you purchased your house with a 5% down payment, but must sell within two or three years, your options will be very limited. There’ll be costs associated with sale – generally estimated at 10% of the sale price – that could wipe out your equity entirely, or even force you to come to the closing table with a check to pay off the excess mortgage balance.
A 20% down payment will almost certainly eliminate that kind of disaster. Not only will you easily cover the closing costs on the sale, but there’s a much greater likelihood that you will walk away with at least some cash to make a down payment on your next property.
In a real way, a 20% down payment is all about keeping your future options open.
Better Protection From Falling Prices
Recessions are bound to happen, and the recent pattern has been that each recession is deeper and more lasting than the one before it. Recessions have a way of hurting property values, particularly when interest rates spike, the stock market tumbles, or unemployment rises significantly. Property values are no longer immune to economic disturbances.
If you make a minimum down payment and the economy tanks, it’s very likely that you will be in a negative equity situation – owing more on the mortgage than the house is worth. That will eliminate your ability to either sell the property to take an out-of-town job, or even to refinance for better terms.
There’s also an important psychological factor involved in negative equity situations. Like a falling 401(k) balance, you just don’t feel as good about life and your future prospects when your house is “underwater”.
You can just about avoid all those problems by making a minimum down payment of 20% on a house. Once again, it’s about keeping future options open!
If You Have to Make a Minimum Down Payment You’re Probably Better Off Renting
So what if you don’t have enough money saved to make a 20% down payment? Wouldn’t it be better to make a minimum down payment of, say 3% or 5% on a conventional mortgage, or 3.5% on an FHA loan, or even 0 down on a VA mortgage? Wouldn’t that enable you to at least get into a house so that you can take advantage of increases in property values?
There are two problems with that reasoning:
- What if the expected property appreciation doesn’t happen – what if property values are stable or even decline? You could be in a worse position than you’re in right now.
- You will be paying more for the house each and every month than you would if you waited until you could save up for a 20% down payment – that’s guaranteed!
The buy real estate at any cost, at any time, under any circumstances crowd will always say otherwise, but I think it’s best to wait until you can save up 20%. That will not only provide all of the benefits that a large down payment brings, but it will also get you in the habit of saving money, and that’s a habit that will benefit you throughout your life.
Minimum down payments are really an attempt to get around saving money, mainly to stimulate real estate sales, not to benefit homeowners. Be a nonconformist, and go against the crowd. Save up for a 20% down payment. And after you’re done doing that, keep on saving money. Your life will go better if you do.