Thoughts about Down Payments
Late last week, I sat down with Don Madisen of PHH Mortgage. We started talking about a client’s mortgage, but then the conversation turned to down payment amounts.
“How much down payment should I make on a home?” The answer varies between buyers. If you’re a buyer with money in the bank but a relatively low annual income, making the biggest down payment possible can be sensible. With a large down payment, your loan size shrinks and reduces the size of your monthly payment. Maybe you may have a good household income but little in the bank. Here, it may be best to use a low- or no-down payment loan while planning to cancel your private mortgage insurance (PMI) in the future.
Here are the general rules for minimum down payment requirements:
• FHA Loan : 3.5% down payment minimum
• VA Loan : No down payment required
• HomeReady™ Loan : 3% down payment minimum
• Conventional Loan (with PMI) : 3% down payment minimum
• Conventional Loan (without PMI) : 20% down payment minimum
• USDA Loan : No down payment required
• Jumbo Loan : 10% down payment minimum
Remember that these requirements are just minimums. Borrowers may put down as much of a down payment as they desire, and it can make sense to put down more. Using a conventional loan to buy a condo is a good example. Mortgage rates for condos are approximately 0.125% lower for loans where the loan-to-value (LTV) is 75% or less. Therefore, 25% down on a condo helps you access lower interest rates. FHA borrowers save with larger down payments too. While 3.5% down payment borrowers pay a FHA mortgage insurance premium of 0.85%, 5% down payment borrowers only see a 0.8% mortgage insurance premium.
Down Payments and Risk
Did you know that large down payments are very risky? Contrary to conventional wisdom, it’s not always “conservative” to make a large down payment on a home and it’s not “risky” to make a small down payment. It’s actually conservative to borrow more! Real estate investors have known this for years. Think like a real estate investor.
Large down payments limit your home’s return on investment. Consider a home which appreciates at the national average of near 5 percent. A home purchased today for $400,000 is worth $420,000 in one year. The size of the down payment has nothing to do with this growth.
How much did you earn on your investment (down payment)?
• With 20% down on the home ($80,000), your rate of return is 25%. ($20,000 profit / $80,000 down payment)
• With 3% down on the home ($12,000), your rate of return is 167%. ($20,000 profit / $12,000 down payment)
However, we must consider the lower down payment’s higher mortgage rate plus mandatory PMI which accompanies loans with less than 20% down payments. Assuming a realistic 1.75% increase from rate and PMI combined, we learn that our low-down payment homeowner pays an extra $6,780 per year to live in their home.
But does it matter? Assuming only three percent down and making adjustment for rate and PMI, the rate of return on a low-down payment loan is 280%. The less you put down, the larger your potential return on investment.
Your down payment is locked away
Upon purchase, the down payment becomes home equity. Home equity is the difference between what your home is worth on paper and what is owed to the bank. 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.
The illiquidity of home equity is why conservative investors prefer the smallest down payment possible. Small down payments preserve your cash. Large down payments tie up cash. You can only access illiquid home equity from home loan refinances or by selling your home, and both of those options cost money and take time. If you have an emergency and you need to access your money now, a refinance requires 3-8 weeks. Selling your home may take even longer.
Large down payments are nice because they lower your monthly payment. But you put yourself at risk when you make a large down payment at the expense of your own liquidity. Conservative investors know to keep their down payments small. It’s better to be liquid when “life happens.”
What if your home value drops?
The link between the economy and home prices is the third reason to consider a small down payment. In general, as the U.S. economy improves, home values rise. When the U.S. economy sags, home values sink. Buyers with large down payments find themselves over-exposed to economic downturns compared to buyers whose down payments are small.
Consider the purchase of a $400,000 home and two home buyers, each with different ideas about how to buy a home. One buyer makes a 20% down payment to avoid PMI. The other buyer wants to stay as liquid as possible, and puts down just 3.5%. The first buyer takes $80,000 from the bank and converts it to illiquid home equity. The second buyer puts $14,000 into the home.
Over the next few years, the economy falters. Our two buyers lose 20% of the value of each of their homes, bringing their values down to $320,000. Neither buyer has any equity left. Our first buyer lost all $80,000 of their money. That money is lost and cannot be recouped except through the housing market’s recovery. The second buyer lost only $14,000. While the second buyer’s home is “underwater,” with more money owed on the home than the home is worth, the bank has the risk of loss and not the borrower.
Let’s say that both borrowers default and no longer make their payments. Which homeowner will the bank 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 foreclosure. A bank’s losses are limited to when the home is sold at foreclosure. The homeowner’s twenty percent home equity is already gone, so the remaining losses (legal and home prep costs) are easily absorbed by the bank. Foreclosing on an underwater home will lead to great losses. All of the borrower’s money is already lost. The bank will not only have legal and home prep costs, but will also have to write down $66,000 in lost value.
Conservative borrowers recognize that risk increases with the size of the down payment. The smaller your down payment, the smaller your risk.
Would you like to talk more about mortgages? I can’t recommend Don Madisen of PHH Mortgage enough. Or, please give me a call! It’ll be my pleasure to help you navigate the world of mortgages, home buying, and the math that affects you.