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Posted 01/28/2017

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Before Making A 20% Mortgage Down Payment, Read This

It's risky to make a large downpayment

In this article:

What is a down payment? And, how much down payment is required?

Why are down payments required? It's probably not the reason you think.

Should I make a large down payment? Why it's riskier to make a large down payment than a small one.


What Is A Down Payment?

A down payment is the amount of cash you put toward the purchase of a home.

It is expressed as a percentage. For instance, $40,000 down on a home costing $200,000 is equal to a 20% down payment.

 Home Price Down Payment Percentage  Down Payment Amount
 $200,000  3%  $6,000
 $200,000  5%  $10,000
 $200,000  10%  $20,000
 $200,000  20%  $40,000

Loan programs today allow you to choose almost any down payment you would like – even 0%.

So, the question most home buyers face right away is, “Should I make a large down payment?”

Each buyer should come to his or her own conclusion. But it’s becoming more popular not to make a large down payment, for several reasons.

Click here to get a live rate quote (Jul 22nd, 2017).

Why Are Down Payments (Sometimes) Required?

Down payments are all about lowering risk for the bank.

The theory goes, if the home buyer has more of their own cash invested in the property, they are less likely to default on the loan.

The theory is flawed.

VA loans, for instance, require zero down, yet have one of the lowest default rates of any loan type.

And, low default rates may not be caused by the high down payment itself. Those who have access to a massive down payment are probably also more financially stable and firmly planted in their careers.

Their high down payment may have nothing to do with the fact that they did not default.

So, while you might hear that it’s more “conservative” to make a large down payment, it’s only partly true: it’s more conservative for the lending institution.

A large down payment is actually riskier for the home buyer.

Click here to get a live rate quote (Jul 22nd, 2017).

Should You Make A Large Down Payment?

There’s nothing wrong with making a large down payment. Those who can do so without depleting all their assets perhaps should.

A large down payment helps you afford more house with the same payment.

Monthly Payment + est. PMI  % Down  $ Down  Loan Amount  Home Price
 Buyer A  $1,000  5%  $9,900  $188,100  $198,000
 Buyer B  $1,000  10%  $21,500  $193,500  $215,000
 Buyer C  $1,000  20%  $52,400  $209,600  $262,000

Even though a large down payment can help you afford more, by no means should a home buyer use their last dollar to stretch their down payment level. It’s not conservative at all, for the following three reasons.

1. You can’t get your down payment back (easily)

The whole point of a down payment is to tie up money in the house.

With that money unreachable, lenders say, the homeowner will continue to make their payments.

That’s not necessarily a bad thing. The money is “sitting there” for when you sell the house someday.

However, a financial event can leave you wishing you had access to the money without selling. Say you lose a job for three months. An extra $20,000 would be a nice safety cushion.

And, if you lose your source of income, you can’t take home equity out via a cash-out refinance or home equity line of credit (HELOC). Lenders won’t approve a new loan to someone between jobs.

In short, the more you need to get at the money, the less access you have to it.

2. You’re at risk when home value drops

A down payment protects the bank, not the home buyer.

Home values are tied to the U.S. economy. Most of the time, the economy is making incremental gains, and home prices rise.

But sometimes, the economy falters. This usually happens after extended periods of too-hot growth. That happened in the late 2000s.

In this situation, consider two home buyers:

  • Buyer A: Puts 20% down on a $300,000 home
  • Buyer B: Uses FHA to put 3.5% down on a $300,000 home

Buyer A, thinking he is being “conservative” puts $60,000 down on a home. Buyer B puts down just $10,500.

If home values fall 20% neither Buyer A nor Buyer B have any equity in their homes. However, Buyer A lost a much bigger amount.

Plus, Buyer B carries less risk of being foreclosed on if she can no longer make her payments. This is because banks know they will take a bigger loss repossessing a home with a larger outstanding loan balance.

So, really, which home buyer is more conservative? The one who puts the least amount down.

Click here to get a live rate quote (Jul 22nd, 2017).

3. 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. Irrespective 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-downpayment 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-downpayment homeowner pays an extra $6,780 per year to live in its home.

Not that it matters.

With three percent down, and making adjustment for rate and PMI, the rate of return on a low-down-payment loan is still 106% -- much higher than if you made a large down payment.

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

Use A HELOC To Increase Liquidity

If you’ve already made a large down payment, you can still decrease your risk with a home equity line of credit.

Do it while the economy is doing well, lenders are offering HELOCs, and you have a job. If any of these factors evaporate, access to your home’s equity is extremely limited.

You can open a zero-balance line of credit. You pay nothing in interest until the moment you draw funds from it. It's just like a credit card (with much lower rates of interest).

For instance, you open a HELOC with a $100,000 limit. You draw nothing. In an emergency, you draw $5,000 per month or as needed, until you're back on your feet.

It’s a convenient, low-cost way of turning your home’s equity into potential cash.

And if your home value drops or you lose your job, you can still take cash out. The terms of the HELOC don’t change based on home value or employment status.

A zero-balance HELOC is probably the easiest way to build a financial cushion quickly if you’ve tapped most of your liquid assets to make a large down payment.

What Is My Eligibility For A Low Down Payment Loan?

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.

Click here to get a live rate quote (Jul 22nd, 2017).

The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.

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