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.
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.
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.
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.
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.
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.
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.