understanding gift tax

How Big of a Down Payment on a House

If you are going to buy a house, it is probably one of the biggest purchases of your life.

Depending on where you live, a house can range from $100,000 to multiple millions of dollars. With a purchase price that is that high, it makes it difficult if not impossible to pay for it in cash.

Most people are forced to take out a mortgage or a loan for the purchase price of their house. A typical mortgage will last between 15 and 30 years. Your monthly mortgage payments are going to depend on the terms, interest rates, and down payment that you put down on your house.

In the past the conventional wisdom was to always put down 20% for a down payments. Is that still the rule of thumb for a mortgage today?

What is a Down Payment

A down payment is a percentage of the purchase price that goes to the seller. The rest of the purchase price is paid down in the form of a mortgage.

Down payments are typically expressed as a percentage. For example, you may hear about a 10% or 20% down payment. On a house that cost $200,000, that is a $20,000 or $40,000 down payment. The $180,000 or $160,000 that is left over would be paid down with a mortgage.

As you can see, the higher your down payment, the less mortgage you will have, and the lower your monthly mortgage payments will be. Unfortunately, down payments must be saved for and given in full. If you haven’t saved a lot over your life, it makes it difficult to give a large down payment.

Mortgage companies require down payments on home to reduce their risk in the loan. The more you have invested into your home, through a down payment and mortgage payments, the less they will lose if they must foreclose on the home. A forecloser happens when you can no longer make mortgage payments and they must take back the home.

Understanding PMI Insurance

For most homebuyers trying to decide on a down payment, it all comes down to avoiding PMI insurance. PIM stands for private mortgage insurance and is insurance for the lender when you have a down payment less than 20% of the house. It is there to protect the lender in case the borrower defaults on the loan and they are forced to foreclose on the home.

When the down payment is above 20%, the lender is more confident that they will be able to recoup the loan even if they are forced to foreclose on the home.

Typically, homeowners will pay PMI as an extra cost on their mortgage payment. There are ways to pay PMI upfront in a lump-sum, but it is usually a monthly charge on top of your mortgage payment.

PMI will range from 0.3% to 1.2% of the mortgage amount. The actual amount depends on property location, size of down payment, and how the property is used (primary residence or investment property).

For a lot of loans, PMI will be eliminated once your loan-to-value drops below 80%. The loan-to-value (LTV) ratio determines how much of a loan you have depending on the value of your home. If your home is valued at $200,000 and you have a loan worth $180,000, your LTV is 90%. You can lower your LTV by paying down your loan and by having the value of your home increase.

With understanding LTV ratio, does it make sense to pay down the mortgage early to eliminate PMI? That is, should you put down more money every month until the LTV ratio is below 80%?

Paying off your PMI early can have a high return on investment. In fact, the return will probably be above what you could hope to gain in the stock market, especially if your PMI is a greater percentage of the mortgage. Looking at paying off PMI as a short-term return makes sense, but we really need to look at the return over the life of the loan. Once PMI is gone, the return gained drops significantly over the life of the rest of the loan. When compared to investing in a conservative portfolio in the market, the return of paying down PMI doesn’t come close to beating your market return, especially if your PMI is a smaller percentage of your loan.

The truth is that PMI should not be feared. It will add additional costs to your loan but based on your situation, the cost may be extremely small. Paying off the PMI early may make sense in your situation when compared to investing in the stock market. A lot will depend on your risk tolerance in the market and how much you are paying in PMI.

Loan for a Down Payment

For most homebuyers trying to decide on a down payment, it all comes down to avoiding PMI insurance. PIM stands for private mortgage insurance and is insurance for the lender when you have a down payment less than 20% of the house. It is there to protect the lender in case the borrower defaults on the loan and they are forced to foreclose on the home.

When the down payment is above 20%, the lender is more confident that they will be able to recoup the loan even if they are forced to foreclose on the home.

Typically, homeowners will pay PMI as an extra cost on their mortgage payment. There are ways to pay PMI upfront in a lump-sum, but it is usually a monthly charge on top of your mortgage payment.

PMI will range from 0.3% to 1.2% of the mortgage amount. The actual amount depends on property location, size of down payment, and how the property is used (primary residence or investment property).

For a lot of loans, PMI will be eliminated once your loan-to-value drops below 80%. The loan-to-value (LTV) ratio determines how much of a loan you have depending on the value of your home. If your home is valued at $200,000 and you have a loan worth $180,000, your LTV is 90%. You can lower your LTV by paying down your loan and by having the value of your home increase.

With understanding LTV ratio, does it make sense to pay down the mortgage early to eliminate PMI? That is, should you put down more money every month until the LTV ratio is below 80%?

Paying off your PMI early can have a high return on investment. In fact, the return will probably be above what you could hope to gain in the stock market, especially if your PMI is a greater percentage of the mortgage. Looking at paying off PMI as a short-term return makes sense, but we really need to look at the return over the life of the loan. Once PMI is gone, the return gained drops significantly over the life of the rest of the loan. When compared to investing in a conservative portfolio in the market, the return of paying down PMI doesn’t come close to beating your market return, especially if your PMI is a smaller percentage of your loan.

The truth is that PMI should not be feared. It will add additional costs to your loan but based on your situation, the cost may be extremely small. Paying off the PMI early may make sense in your situation when compared to investing in the stock market. A lot will depend on your risk tolerance in the market and how much you are paying in PMI.

0% Down Payment on a House

Typical lenders will not let you put down 0% on a house. This brings a high risk to the lender that if you default the lender will be on the hook for the entire loan.

However, if you are U.S. military service personal, veteran, or their family, you can qualify for zero-down loans backed by the U.S. Department of Veteran Affairs. Along with a zero percent down payment you can also receive capped closing costs and no broker fees.

3.5% Down Payment on a House

If you or a family member are not active military or a veteran, the next type of loan you could qualify for is an FHA loan. FHA, Federal Housing Administration, loans are backed by the government. They will allow down payments as low as 3.5% if your credit score is above 580. If your credit score is below 580, the down payment requirement goes up to 10%.

If you are a first-time homebuyer, an FHA loan can be a good way to go. These are ideal due to the lower down payment and credit score requirements. According to The Lenders Network, “in 2017 approximately 46% of first-time buyers used an FHA loan to buy their first home.”

Not only do FHA loans not meet the 20% requirement to avoid PMI, they will also require that you keep PMI for the entire life of the loan. Even when your LTV value goes below the required 80%, you will not be able to remove PMI unless you refinance your loan.

20% Down Payment on a House

You already know that one of the biggest benefits to a 20% down payment is the lack of PMI. On top of paying less every month due to lack of PMI, you will also pay less due to the size of your loan. As interest adds up over the life of the loan, it increases the cost of your home.

The higher the down payment, the lower your interest rate will probably be. Again, this will go to lowering the overall cost of your home.

The Downside to Large Down Payments

Putting as much money down as you can is not always the best idea. It really depends on your views and goals.

If having debt weighs on you mentally, it is probably better to put more money down and remove the debt as fast as you can. The feeling of not having a home loan or debt can be a great burden lifted from your shoulders and benefits can vastly outweigh the greater return of not paying your house down early.

If your goal is to maximize your return, a larger down payment and paying off your house quick is not ideal. A larger down payment will lower your return.

If your home was valued at $200,000 and is now valued at $220,000, your home value went up by $20,000. Nothing you did, in terms of down payment, affected how much your home was worth.

If you put 10% down, $20,000, your rate of return is 100%. You used $20,000 to make $20,000. If you put down 20%, $40,000, your rate of return is 50%. You used $40,000 to make $20,000.

The larger your down payment, the less money you have in the bank. Remember, money spent on a down payment is money that cannot be used for other things. You cannot access your down payment once it is spent. Yes, your home equity will build, but it is an illiquid asset that is hard to access. You can get access to it if you sell your home or refinance.

Conclusion

Unfortunately, there is no right answer when it comes to how much you should put down on a house. Each down payment range offers a different pro and con list to be considered. Too many people consider the 20% down payment as the only way to go when in truth, there are many other ideal options.

What is more important is buying a home that you can afford. Before purchasing a home, understand what the mortgage will be, how much PMI is going to cost you, what your homeowner’s insurance is going to cost, and don’t forget about property taxes. You need to consider the cost today and in the future. Your mortgage payment may stay the same, but insurance and property taxes are going to continue to climb.

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