Unlocking Your Dream Home: The Savvy Buyer’s Guide to Down Payments

Unlocking Your Dream Home: The Savvy Buyer’s Guide to Down Payments

Have you ever stood at the edge of a diving board, feeling the cool breeze, hearing the water gently lap below, your heart racing with a mix of excitement and nerves? You know that the leap is inevitable, and once you take the plunge, there’s no turning back.

In many ways, buying a house mirrors that experience. It’s an exhilarating adventure, filled with anticipation, dreams of the future, and often a truckload of questions—especially when dollar signs get involved. Among the maze of information, one piece of advice seems to echo louder than others: the ‘golden rule’ of 20% down payments. But is this really the magic number, or is there more to the story?

Join me as we dive deep (yes, another pun!) into the world of mortgages, down payments, and everything in between. We’ll debunk some myths, clarify the truths, and empower you to make the most informed choice for your dream home.

Down Payments 101: What’s the Real Deal?

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 homes 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 foreclosure happens when you can no longer make mortgage payments, and they must take back the home.

Navigating the Waters of PMI Insurance

For most homebuyers trying to decide on a down payment, it all comes down to avoiding PMI insurance. PMI stands for private mortgage insurance, and it is insurance for the lender when you have a down payment that’s 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, the size of the 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, then 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 the 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.

The Piggyback Solution: Double Loans for Bigger Down Payments

Maybe you’ve decided that it is important to you to put 20% down on your new home. However, you want the home now and don’t have 20% saved.

There is a solution known as a piggyback loan. This loan will let you borrow the remaining down payment. If the home you want is $200,000 and you only have 10% saved ($20,000), then you can take out a piggyback loan for the other $20,000. This would give you a 20% down payment on your house, but it would also give you two loans.

Is this a good idea?

The drawback is that this piggyback loan will have a higher interest rate and a shorter-term limit. This can give you a higher monthly payment and can make cashflow tight until you pay off this piggyback loan.

The No-Strings-Attached 0% Down Payment

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

However, if you are U.S. military service personnel, a 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.

FHA Loans: A Glimmer of Hope for First-Time Homebuyers

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, or 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, then 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, but they 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.

Why 20% Down Isn’t Always the Golden Number

You already know that one of the biggest benefits of a 20% down payment is the lack of PMI. On top of paying less every month due to the 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 Catch-22: The Pros and Cons of Generous 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 quickly 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 the down payment, affected how much your home was worth.

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

Your Home Buying Action Plan

1. Evaluate Your Finances: Start by understanding your current financial position. Check your savings, debts, monthly expenses, and credit score.
2. Understand Mortgage Basics: Familiarize yourself with key mortgage terms, like interest rates, terms (15 or 30 years), and monthly payments.
3. Research Down Payment Options:
   • Consider your comfort level with different down payment percentages.
   • Explore loan options and programs tailored to specific down payment amounts.
4. Get the Lowdown on PMI:
   • Understand what PMI is and when you might need to pay for it.
   • Consider the long-term implications and costs of PMI on your mortgage.
5. Consider the Piggyback Loan: If you’re short on a 20% down payment but want to avoid PMI, see if a piggyback loan is a viable option for you.
6. Look into Special Loan Programs:
   • For military personnel and veterans, explore the benefits of VA loans.
   • For first-time buyers or those with lower credit scores, research FHA loans.
7. Run the Numbers: Use online mortgage calculators to see how different down payment percentages affect your monthly payments and overall loan costs.
8. Weigh the Pros and Cons of Large Down Payments: Understand the long-term implications of larger down payments on the cost of your home and potential returns.
9. Stay Updated on Other Costs: Remember, the mortgage isn’t the only cost. Keep tabs on potential homeowner’s insurance costs, property taxes, and any homeowner association fees.
10. Consult a Financial Planner: Before making the final decision, consider discussing your options with a financial planner to ensure you’re making the best choice for your specific circumstances.
11. Stay Informed: Real estate and loan policies evolve. Keep yourself updated, especially if you’re considering buying in the near future.
12. Finalize and Celebrate: Once you’ve made your decisions and sealed the deal, take a moment to celebrate this significant milestone in your life!

Conclusion

Homeownership is a journey, not a destination. And every journey is unique, with its twists and turns. While many may advocate for the 20% down payment as the ultimate path, it’s essential to remember there’s no one-size-fits-all approach. Your financial landscape, future goals, and comfort levels play pivotal roles in this decision. So, rather than chasing a universal ‘right answer,’ focus on what aligns best with your circumstances.

Take into account the entire financial picture: from mortgage rates and PMI to insurance and property taxes. And as these numbers dance around, ensure they harmonize with your future projections and current realities. Remember, buying a home is as much an emotional decision as it is a financial one. So, equip yourself with knowledge, trust your instincts, and set forth confidently on this exciting journey. After all, it’s not just about buying property; it’s about building a haven.

Glossary

1. Mortgage: A legal agreement by which a bank or other lender lends money at interest in exchange for taking the title of the debtor’s property, with the condition that the conveyance of title becomes void upon the payment of the debt.
2. Down Payment: An initial payment made when buying something on credit. In the context of buying a house, it’s a percentage of the home’s purchase price.
3. PMI (Private Mortgage Insurance): Insurance that compensates lenders if a borrower defaults on a loan. It’s typically required when a borrower can’t make a down payment of at least 20% of a home’s purchase price.
4. Foreclosure: The action of taking possession of a mortgaged property when the mortgagor fails to keep up their mortgage payments.
5. Loan-to-Value (LTV) Ratio: A financial term used by lenders to express the ratio of a loan to the value of the purchased asset. It helps determine how much equity someone has in their property.
6. Piggyback Loan: A type of mortgage which is taken out in addition to a primary mortgage, and is used to cover a portion of the down payment. It helps borrowers avoid the need for PMI.
7. VA Loan: A mortgage loan issued by private lenders and partially backed by the U.S. Department of Veterans Affairs. It helps U.S. veterans, active-duty service members, and widowed military spouses buy homes.
8. FHA Loan (Federal Housing Administration Loan): A government-backed home mortgage loan for low-to-moderate income borrowers. It allows for a lower down payment and has less stringent credit requirements than standard loans.
9. PMI Elimination: Reaching a point (typically an LTV below 80%) where PMI is no longer required, reducing the monthly mortgage payment.
10. Equity: The value of ownership interest in the property, calculated by the market value of the property minus any liens or loans against it.
11. Refinance: The process of obtaining a new mortgage, typically with better terms, to replace an existing mortgage.
12. Home Equity: The market value of a homeowner’s unencumbered interest in their real property; the difference between the property’s market value and the amount of any liens.
13. Credit Score: A number assigned to a person that indicates their capacity to repay a loan, based on their credit history.
14. Homeowner’s Insurance: A form of property insurance that covers damages and losses to an individual’s residence and assets in the home.
15. Property Taxes: Taxes assessed on real estate by the local government, based on the estimated value of the property.