First Time Home Buyer Series: How Much Should I Put Down on Buying a Home? Understanding the Pros & Cons of the Downpayment

If you’ve started the home buying process and are looking for more information on the pros and cons of a low vs. high downpayment, you’ve come to the right place.

In this post, I will be reviewing (jump links below):
– Downpayment Options
– Financial Scenarios for a Low & High Downpayment
– Investing the Difference: Does it Make Sense
– Q&A: Which Downpayment Option Makes the Most Sense?
– Summary

Downpayment Options

If you’re planning on buying a house with traditional financing, then you are going to have to put a percentage of the home purchase price down at the time of closing.

There are largely two buckets of downpayment options:
1) Low/No Down
2) High Downpayment (20%+)

Low/No Down Options
VA Loans are famous for their no down payment component, which is designed to make it much easier for veterans and active duty service members who qualify to purchase a home.

FHA Loans, offered by the Federal Housing Agency, are a well-known low down (as low as 3.5%) option as well.

“High” Downpayment
I say high, because it is high relative to the low/no down options at 20% or more of the purchase price. On a $325,000 home, that is the difference between a $16,250 downpayment at 5% and a $65,000 downpayment at 20%.

Let’s take a look at some financial scenarios and see the impact from each, borrowing the examples I shared in this article (First Time Home Buyer Series: How Much Savings Do You Need to Buy a House? Part 2/2).

Downpayment Financial Scenarios

Scenario 1: Paying 5% Down

• Home Purchase Price = $325,000
• Home Loan Amount = $308,750
• Major Up-Front Out-of-Pocket Expenses = $22,750
  • Downpayment = $16,250
  • Est. Closing Costs @ 2% = $6,500 (range from 1-3%)
• Monthly Expenses = $2,078++
  • Principal & Interest Expense = $1,496
  • Taxes = $219 (rough est., check for your area)
  • Homeowners Insurance = $233 (rough est., check for your area)
  • Private Mortgage Insurance (PMI) = $129
  • Factor in Maintenance as well

Scenario 2: Paying 20% Down

• Home Purchase Price = $325,000
• Home Loan Amount = $260,000
• Major Up-Front Out-of-Pocket Expenses = $71,500
  • Downpayment = $65,000
  • Est. Closing Costs @ 2% = $6,500 (range from 1-3%)
• Monthly Expenses = $1,713++
  • Principal & Interest Expense = $1,260
  • Taxes = $219 (rough est., check for your area)
  • Homeowners Insurance = $233 (rough est., check for your area)
  • Factor in Maintenance as well

Let’s compare the two options, as they each have pros and cons.

A low downpayment may be a good option for you, if:

• Owning a home as quickly as possible is important to you
• You don’t want to invest the bulk of your savings in an illiquid asset
  • For our $325,000 home example, the downpayment was
    • $16,250 @ 5%
    • $65,000 @ 20%
  • Curious if your home an asset, or a liability? Read more here.
• You don’t have enough savings to maintain an Emergency Fund AND pay for a downpayment and closing costs
  • Read More Here on savings and an Emergency Fund
  • Read More Here on saving up for a downpayment
• You are planning on moving to a new location in less than 5-10 years

A high downpayment may be a good option for you, if:

• Want to save thousands of dollars on PMI (Private Mortgage Insurance). In our above 5% down example, it works out to be around $129/month, assuming you have a decent credit score.
• Want to save significantly on interest cost (ex: $36,306)
  • @ 20% down on a $325,000 home with a 4.125% interest rate on a 30-year loan equates to
    • $1,260/month in Principal & Interest Payments
    • $193,632 in interest payments over the course of the loan, assuming no pre-payments
  • @ 5% down on a $325,000 home with a 4.125% interest rate on a 30-year loan equates to
    • $1,496/month in Principal & Interest Payments
    • $229,938 in interest payments over the course of the loan, assuming no pre-payments
  • That’s a difference of $36,306 over the course of a 30-year loan ($229,938 – $193,632), assuming you live there the whole time
• That works out to $236/month difference on the principal and interest payments alone. Add in PMI at around $129/month and now the monthly difference is $365, which may not sound so large, but that’s $4,380/year.
  • It will take you around 7 years of paying PMI, with no additional payments to hit the 20% home equity mark and get rid of your PMI. So, you will be paying around $10,836 just for PMI over that period.
• As you can see, a low down strategy can be a winner in the short-term, and a loser in the long term…but there’s a bit more to it.

So…does it ever make sense to go with the lower downpayment?

Yes. Take a look below.

Using a conservative 2% annual appreciation rate, you can see that even after subtracting 6% for a real estate agent fees and 2% for closing costs and other miscellaneous fees, you’re still better off financially by paying PMI and the additional interest expense from the lower downpayment (5% in this example). This trend continues over time.


Does a low downpayment make sense always…? No
The above example is based on the underlying assumption of real estate prices increasing over time. If you are unfortunate enough to buy at a high point and need to sell at a lower point, paying a higher interest expense and PMI will make you worse off financially than having paid 20% down.

Why? Let’s take a look.

In this $325,000 priced home example, instead of planning for long-term appreciation, we are stress testing which downpayment strategy would be better in a downturn, in which you have to sell.

Let’s say that home prices are decreasing at a rate of 2% a year (mild downturn). At the end of 2 years, when you end up having to move and sell your home in our fictional example.
– Your home value has decreased by $12,233 to $312,767 (loss in home value is the same regardless of the downpayment amount)
– We can ignore selling costs, because they are the same whether you put 5% or 20% down

If you paid 5% down ($16,250):
– PMI and a higher interest expense (at the same 4.125% 30-year loan as our 20% down example) would cost you an additional $8,760 at the end of 2-years. This is the amount that you have “lost” vs. having paid 20% down.

So, one question is, do you have reason to believe that real estate prices will increase over your planned holding period?

If instead of a 2 year period, if we used 5 years instead, the increased expense from PMI and higher interest would have been closer to $21,900.

Another question, have you quantified the dollar risk associated with the potential for declining house prices (like we did above)? Is that acceptable for you?

Be sure to know what you are getting into when you make a large financial decision like buying a home and deciding how expensive of a home to buy and what downpayment to make.

What if you have the money for a 20% downpayment and an Emergency Fund? Is it a smart move to put 5% down and invest the difference?

Again, we have to revisit our risk tolerance and our expectations about the outlook of the economy. How far in advance you plan also makes a large difference. The short answer though is no for most people.

The difference between a 20% downpayment and a 5% downpayment on the $325,000 home example is,
$65,000 – $16,250 = $48,750 in investment capital.

If you wanted to take a more aggressive strategy, you could invest that money in the stock market or other investment vehicle.

Required Rate of Return
– Additional cost of $129/month for PMI (assuming 5% down)
– Because you are paying 4.125% on a $308,750 loan, instead of on a $260,000 loan, the difference in monthly interest rate is roughly (varies slightly each month as you pay down the loan) $236,
– for a total of $365/month in additional cost, or $4,380/year

Assuming
1) that you have a holding period > 1 year, and
2) you earn between $39,376 to $434,550 a year

You will be taxed at long-term capital gains at 15%.

And, let’s say you aren’t a professional stock picker, and so you decide to buy a low cost ETF or index fund. The expense ratio fees can differ quite a bit, but let’s say you pick something on the more cost effective end at 0.04%.

In order to be able to earn back the difference in what PMI and the higher interest expense cost us, we will need to earn:
– $4,380/year

Fast forward 5 years to when you plan to move.
If you’ve picked well and had favorable market conditions, you made money. Let’s say you averaged 5% a year for each of the last 5 years.

So, how did we do investing the difference vs. putting 20% down?

PMI and the additional interest expense cost us $21,900.
We made $11,448 on our investments after tax.
= We lost $10,452.

What if we made 9% a year instead of 5%?

We net $419. That is a very narrow margin of safety. Warren Buffet and many other investors believe that having a margin of safety is required in order to make money. So we are going to add an additional 30% margin of safety to our required $21,900 to make it $28,470. This means that we would need to achieve an average 11% return on investment (ROI) over the 5 year period.

Everyone’s investing skills are different, but the compound annual growth rate on the S&P 500 from Jan.1 1919 to Dec 31 1919 was 10.47%. In a shorter period of time like 5 years, the market can be much more volatile.

Do you have reason (and a track record) to believe that you can beat the market?
If not, putting the 20% down is likely the dominant strategy here. The market doesn’t always go up, and if you used this strategy in a bear market, you would be out not only the $4,380/year for PMI and higher interest expense, but also your investment capital would be reduced as well compounding the loss.

What if I just kept the money in the bank?
Well, it would take around 11 years to “lose” the money. In other words, the difference between at 20% and a 5% downpayment is $48,750 on a $325,000 house. You wouldn’t really lose that money, but your annual income would be reduced by around $4,380 a year, and after a little over 11 years you would have paid the difference.

If you planned on selling in a shorter period of time, like in our example above, in an appreciating real estate market you would come out ahead.

Summary

We’ve looked at the impact of appreciating real estate markets, real estate agent fees, holding period and several other factors.

If you believe:
– real estate prices will continue to increase during your planned holding period and that now is a good time to buy
– you can afford the monthly expense
– Don’t have enough savings to maintain an Emergency Fund and pay the downpayment and closing costs
– going for a lower downpayment may be a good option for you

If on the other hand:
– Have an Emergency Fund and required downpayment and closing costs saved up
– Want to minimize your monthly expense
– Really don’t have any idea what the real estate market will do over your holding period and are concerned with potentially losing money on your home
– going for a 20% downpayment may be a reasonable option for you