Written by Carissa Abazia
“Price is what you pay. Value is what you get,” said the great Warren Buffett. In other words, don’t focus on short-term swings in price; focus on the underlying value of your investment.
There are many reasons why people don’t purchase residential property: From appraisals and inspections to closing costs and down payments, the upfront cash required can take years to save. However, thanks to low-down-payment loans now on the market, homeowners can have keys in hand with significantly less cash upfront.
This begs the question: Is purchasing a house with little to no money down a good financial move?
As a mortgage professional, my goal is to put families into homes. If my customer wants to invest in property, but isn’t sure if she or he can, I help them by weighing their down payments options. Waiting to save up 20% is not the only option, and they may be better off buying a home today with a smaller down payment rather than waiting.
Buy vs. Wait Example:
Let’s assume someone is saving for a 20% down payment on a $400,000 home. They have saved $20,000 of the $80,000 they need for a 20% down payment and can add $500 to savings each month – $6,000 a year.
Here is a breakdown of how they could buy a home with as little as 3% down, and the cost if they were to purchase today with 5% down (the amount they has available today). This is assuming a 5% interest rate.
It also shows that if home prices appreciate at 3% annually, their future 20% down payment will need to be $143,823 and close to 20 years to save. During that time, they will have paid more than $288,000 in rent.
None of this is meant to encourage a prospective borrower from buying a home before they are ready. It is in everyone’s best interest for borrowers to succeed, so borrowers need to be comfortable not only with the mortgage payment but also the other responsibilities that come with homeownership.
If you’re contemplating a home purchase, here are a few things to consider.
There are several no- or low-down-payment loan options available for a wide array of financial situations. We’ll highlight just a handful.
VA loans: Reserved for active-duty and honorably discharged service members, reserves, National Guard members with at least six years of service, and spouses of service members killed in the line of duty, VA loans require 0% down and no private mortgage insurance.
USDA loans: Also known as the “rural housing loan,” this 0%-down loan is meant to help low- to moderate-income households in eligible areas that are in need of housing but may be unable to qualify for other loans.
FHA loans: With more lenient approval requirements than conventional loans, FHA loans also require as little as 3.5% down. However, mortgage insurance premiums will have to be paid for the life of the loan.
Conventional loans: It’s possible to get a conventional loan with as little as 3% down, but just as with FHA loans, there’s an additional requirement of private mortgage insurance (PMI). However, once you reach 20% equity in the home, this additional cost can be dropped.
What are some of the reasons to put less than 20% down on a home?
You don’t have the cash upfront
Many people struggle to come up with a 20% down payment, but that doesn’t mean they can’t handle the monthly mortgage costs. For example, you may have recently paid off your student loans, leaving you free of debt but also leaving you without enough savings to afford a lump-sum payment at the beginning of your home-buying journey.
You aren’t planning on staying in the home for the long run
It’s a gamble to purchase a home you plan to sell within a shorter time frame (say, three to five years), but if that’s the plan, the cost of a 20% down payment could wash out the savings of a lower monthly payment. Plus, this practice puts your potential profit from the sale of the home at risk, since you’ll need time to build equity (and hope real estate prices rise).
You need the liquid funds
Whether you prefer a larger emergency fund, plan to invest liquid assets elsewhere, or need cash to put toward a home remodel, you may want to protect your liquidity by minimizing the amount of your down payment. It’s all about your personal comfort level when it comes to your finances.
What are the upsides to making a smaller down payment?
1. Your money might be more useful elsewhere
There’s a chance the money could offer a bigger savings or return if used elsewhere. For instance, if you have $20,000 in credit card debt at an interest rate of 16% and a minimum monthly payment of 2% of the balance, you would be paying $400 per month (plus interest). Now let’s say you want to buy a $200,000 house at 3.92%. A down payment of $40,000 would put your mortgage payment at $756.50 (plus the additional $400+ per month for the credit card). However, if you cut the down payment in half (to redirect the funds to pay down the credit card) and increase your home-loan interest rate to 4.02%, your total monthly mortgage payment would be $861.42. In this case, the greater monthly savings comes from paying off the card.
2. You can keep your cash liquid
Unless you plan to move out, pulling equity out as cash requires refinancing — a potentially costly endeavor. A lower down payment can keep more of your cash liquid in case life circumstances require a cash expenditure in the near future. Without this cushion, you could potentially put your home (and living situation) in jeopardy.
What are some downsides to a smaller down payment?
1. You may have to pay PMI or mortgage insurance premiums (MIP)
To mitigate the additional risk of lending to a borrower with a small down payment, lenders usually require private mortgage insurance for conventional loans until the homeowner has at least 20% equity in the home. All FHA loans require homeowners to pay mortgage insurance premiums for the life of the loan.
There is an option to elect for “lender-paid-mortgage-insurance” (LPMI) versus “borrower-paid-mortgage-insurance” (BPMI). Typically, the rate with LPMI is slightly higher than with BPMI, but the monthly cost savings are huge if you elect to have LPMI. You can save hundreds of dollars a month with this option.
2. You’re likely to have a higher interest rate
The best interest rates don’t automatically go to the borrowers with the best credit score — the size of the down payment makes a difference as well. This higher rate translates into higher monthly payments and more money spent over the life of the loan.
3. You will have less equity upfront
The less money you put down, the less equity you will have once the home officially becomes yours. This could mean you can’t take advantage of home equity loans or lines of credit if your home needs repairs for which you can’t afford to pay cash. It could also increase your chances of being underwater in your home (owing more than what the home is worth) should the market crash.
So, what’s the bottom line?
Conventional wisdom might say 20% is always the way to go, but more options and different financial circumstances put this to the test. Make sure to fully explore the loan options available to you with your trusted lender before deciding on the down payment amount that suits you and your situation best.
Thanks for reading!
Carissa Abazia
@CarissaMortgage