Down Payments… All or Nothing is the Way to Go

This is my personal take on down payments, and some real examples with the numbers. I hope this helps make your decisions to buy and how much you put down a little easier. Many people I speak with have a certain amount of money saved for a down payment. They are planning to use that specified amount as their down payment, no matter the price of the house. They’re figuring that they’ll at least meet the minimum required by their lender if they find a more expensive home, and if they find a cheaper home, then they’ll have a lot more equity in the home. This sounds great, and to each their own, but I look at things a little differently. If you’re unable to put down 20%, then you shouldn’t spend any more money than you have to for your down payment. Let’s talk about PMI, monthly payments, and how the down payment effects both.

Private Mortgage Insurance, or PMI is a % of the loan that your lender will charge you when you don’t have 20% down. PMI is also called MIP, one for conventional the other for FHA. This is one of the biggest reasons that most people think they need 20% down to buy a home. Read You can probably buy a home, and you didn’t even know it! to learn more. PMI can range, but it’s typically going to be somewhere between 0.5% and 2% of your loan, per year. Let’s put this into dollars and cents, and also put some parameters in place so we can use the same example throughout.

Purchase Price: $200,000

Interest Rate: 4%

PMI Rate: 1%

We will keep the above numbers constant throughout this post. However, since the point of this post is to show you how the down payment affects your monthly costs, we will be playing with that number. If you purchased this home with 10% down ($20k), your loan will be $180,000. PMI would come out to $1800/year, which equates to $150/month. That can drastically change whether or not a home is affordable and/or whether it’s possible for the lender to approve. Your payment on your mortgage, interest, and PMI for this home would be $1009/month–Remember this doesn’t include homeowners insurance or property taxes.

I want to share an estimated rule of thumb that’s fairly easy to remember: $10,000 is $50/month. This rule of thumb usually comes in handy when contemplating an offer. Sometimes people are very worried about their budget when deciding whether or not they want to buy a home a $250k or $260k, and although there are other things to consider when looking at the price of a home, the monthly budget will only change by about $50/month for every $10,000 difference in purchase price. This is also true for down payment.

There’s 2 things to consider with down payment, the liquidity of your money and your risk. So, if you can’t put 20% down (in our example $40,000) then my suggestion is to put down as little as possible. This increases your liquidity and decreases your risk. Hear me out…

It would probably be better to keep your savings in your savings, not in your home

Liquidity. FHA guidelines require a minimum of 3.5% down ($7000 in our example) and Conventional requires 5% down ($10,000). Some people are so hyped up on equity in the home, but this is not liquid money. Your money will be in your house, and the only way to pull it out is if you get an equity loan/line of credit, or sell the house. You’ll pay interest on the equity loan, of course, and when you sell you’ll have costs associated with closing. Obviously you want to avoid being forced into these situations, but that’s where limiting your risk comes in.

Risk. God forbid you are in a situation where the costs of selling your home plus the mortgage payoff will put you in a hole, you’ll lose the equity you have in the home; case and point, real estate bubble/collapse of 2008. When homeowners were being foreclosed on, the people who leveraged (borrowed) the most, and put down the least, were less affected. When you foreclose, you lose the home and any equity you had in the home; if you only put down 3.5%, it’s a little easier to walk away than if you put down 20%.

Putting a lot of money into your home only for the sake of equity is a good idea if you have that kind of expendable income. I’m writing to most people who don’t have gobs of money and are looking to spend the majority of their savings on their home. It would probably be better to keep your savings in your savings, not in your home. Let’s look at a fancy chart to show the difference in monthly payment based on down payment scenarios of 15% and 5% (NOT 20%).

Purchase Price  $    200,000  $    200,000
Down Payment  $       30,000  $       10,000
Loan Amount  $     170,000  $     190,000
Principle & Interest Payment  $               811  $              907
PMI  $               141  $              158
Total Monthly Payment  $             952  $         1,065
Purchase Price  $    400,000  $    400,000
Down Payment  $       60,000  $       20,000
Loan Amount  $     340,000  $    380,000
Principle & Interest Payment  $           1,623  $           1,814
PMI Payment  $              283  $              316
Total Monthly Payment  $         1,906  $         2,130

The monthly payments don’t change that much. Even at the $400,000 price point, the monthly payment only changed by $224. Now, everything is relative, so while $224 is a lot of money per month to spend on coffee, I don’t think it’s a big difference in mortgage payment… especially if you look at the cost that came with saving that $224/month–$40,000!!! That $40k is now tied into your home and you are now super cool with 15% equity… woah, now you can brag to… yourself? No one cares about your equity, and it doesn’t benefit you at all. It’s only a monthly payment difference. You might be thinking, “but Joe, I’m also paying interest on that $40,000 if I don’t put it down.” Yes, you’re right. It’s nice to try to save on interest. However, you’re not going to be living in that house for 30 years right? You’ll probably move within 10 years, maybe sooner if this is your first home. Interest is amortized over the entire 30 year mortgage, and you’ll be paying majority interest for the first 15 years of your loan anyway, regardless of how much you put down. In contrast, let’s look at what changes when you put down 20% and avoid the PMI payments.

Purchase Price  $ 200,000  $ 200,000
Down Payment  $    10,000  $    40,000
Loan Amount  $  190,000  $  160,000
P&I Payment  $          907  $           763
PMI  $           158  $              –
Total Monthly Payment  $      1,065  $          763
Purchase Price  $ 400,000  $ 400,000
Down Payment  $    20,000  $   80,000
Loan Amount  $ 380,000  $ 320,000
P&I Payment  $        1,814  $        1,527
PMI  $           316  $              –
Total Monthly Payment  $      2,130  $      1,527

That’s savings of $302/Mo and $603/Mo at the $200k and $400k price point. It’s costing you more money to do this, but instead of simply saving the $50/month for every $10k, you’re also avoiding the PMI payments. Oh yeah, and you get to feel good about your equity, yay! But really, the benefit is much greater for the additional money you put in. I think that one could even make the argument that it’s never worth it to put 20% down, but instead, pay your PMI payments and keep your savings in your very-liquid bank account; or even better, a growing investment; I don’t like this as much, but it might make sense for some.

Equity is awesome when it’s gained through the increase in value of your home, not if you simply bought it.

This theory is simply based on financial logic, not on situational circumstances. Financial logic says pay as little as possible to acquire an appreciating asset. However, there may be times when you’ll need to put down a little more than the minimum, and it will still make sense, despite everything I just mentioned. Sometimes you might be toeing the line with your approved budget, and you may need to put more money down so that your payment goes down just enough to get approved. If you’re in competition with another offer, putting down the minimum may imply lack of funding and/or financial sense. This may cause the seller to be concerned with your ability to actually get a loan approved, and they may choose another offer that is putting more money down. The last reason I’ll mention to put as much money down as possible, even if you can’t reach the 20% mark, and probably the most logical and likely, would be in the situation of a conventional loan. FHA loans require you to pay MIP for a certain number of years (I believe it’s 15 years), however, a conventional loan has no minimum time frame for PMI payments. Therefore, if/when you reach the 80/20 loan to value (LTV) ratio, you can request your lender to get rid of your PMI payments. If you’re using a conventional loan, and you can’t quite put 20% down, you may want to consider putting as much down as possible; the closer you are to 20% equity, the closer you’ll be to getting rid of your PMI payments. Some people don’t like the idea of owing money–for anything; these people may be looking into options of a 15 year mortgage, or just trying to have as little of a loan as possible, and for them, 20% down or more may make the most sense. Also, my disclaimer on equity. Equity is awesome when it’s gained through the increase in value of your home, not if you simply bought it.

You are free to do what you will, but my advice is to leverage as much as you can. This will keep money in your bank account, which increases the liquidity of your money; furthermore, you’ll be limiting your risk in case of a real estate crisis/recession, and/or a financial bind. All (20%) or none (the minimum) in my humble opinion. 🙂

Thank you for reading! Comments and Questions welcomed!

Joe

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