Thanks Jeremy. Buying a house for me is still two to three years away. I currently have built up a nice emergency fund and on the brink of investing outside of my 401k. Without an exact date/goal for when I will be purchasing a house I am torn between how to properly invest my money. I feel like I would be losing money by continuing to hold the money in my savings account. Any advice?
The shakeup in the housing market over the past several years has brought the need and advantages of a down payment when buying a new home back into focus. In a traditional mortgage, the home buyer was required to provide a 20% down payment at the time of closing. This trend shifted during the housing boom and often allowed buyers to purchase a new home with little or no money down. This practice persisted until the financial meltdown of 2008 brought both borrowers and lenders back to reality and down payments have become a part of buying a new home again. While many of these low or no-interest loans are still available, you will soon see how important that down payment can be.
Financial Advantages of Making a Down Payment
While it is easy to see the historical 20% down payment as a major impediment to acquiring a new home, there are significant advantages to having this money when you buy your house. In addition to having an instant equity stake in one’s home, there are certain cost savings that are associated with the 20% level. Most lenders require Private Mortgage Insurance (PMI) for borrowers who have less than 20% equity in their homes. This is an additional level of insurance coverage that provides the lender with some protection in the case of a default. The charges for the premiums, however, are passed on directly to the borrower. If a borrower makes a 20% down payment, this charge is avoided. Additionally, even if the borrower is unable to hit the 20% mark right from the outset, getting to this of equity in the home can still yield the same savings.
The other significant cost savings that occurs when a home buyer makes a down payment is a dramatic reduction in the amount of interest paid over the life of the loan. Despite the fact that rates have remained low, the interest one must pay on each additional dollar that is borrowed adds up over the life of a typical thirty year mortgage. Over the course of a thirty year mortgage you may pay just as much in interest as you did for the house.
Here is a quick example. Let’s say you find a house that you like and really want to buy it to take advantage of low mortgage rates. The house is going for $175,000. Unfortunately, you don’t have $35,000 set aside for a traditional 20 percent down payment, but you find a lender that can work out a mortgage with just 2 percent down, or $3,500. It sounds great, but guess what? That loan would end up costing you about $120,000 in interest. But that’s not all. It would take roughly 11 years to get to the point where you have enough equity to eliminate PMI. If you assume about $150 a month for PMI on a loan of this amount, that ends up costing you nearly $20,000. Total cost to buy this home without the standard down payment: $140,000.
Let’s take the same house, same mortgage rate, and instead put the full 20 percent down. In this case you’ll only pay about $100,000 in interest over the life of the loan. In addition, you avoid PMI which saves another $20,000. All said and done you save $40,000 by coming to the table with a 20 percent down payment.
Is That Really a Savings?
I know what some of you are thinking. Why save up and dump $35,000 into a down payment today when you could basically finance that over the life of the loan? We haven’t discussed monthly payments yet. The terms of the loan in the first example would put the principal plus interest payment at around $820. Then when you tack on PMI your total monthly payment clocks in at about $970. With the full down payment and avoiding PMI, the monthly payment is just $670. A difference of $300 a month. That’s a nice boost to your cash flow and could go a long way toward making IRA contributions, adding to a college fund, or whatever the case may be.
Even so, people will crunch the numbers and play the “what if” game. What if I used the down payment funds to invest in something that earned more than what the mortgage was costing, what if I was able to get a piggyback loan to avoid PMI, what if…? There are a dozen possibilities, but that’s not the real reason behind striving for a large down payment.
It’s all about equity. Here’s the thing. Most people don’t live in their homes for the life of the mortgage. In fact, only about half of all homeowners stay in a particular home for more than 10 years. Because of the way mortgages work it takes a long time before you start to see the equity build up when making regular payments. So people who need to sell in the first half of the mortgage often end up with little equity without that down payment. And remember, even if you do have a little equity, there are costs to buying and selling a home. Things like real estate broker commissions and concessions to buyers can cut into your “profit” by tens of thousands of dollars, meaning you could end up walking away from the sale with almost nothing in your pocket. Or in the worst case scenario, you end up having to shell out money to get out of the house.
Sources of Funds
Saving to make the down payment on a new home can often be a daunting task given how much money it might take to reach a comfortable down payment. While personal savings is the most common source of down payment funds, there are other options that can be considered. Furthermore, properly managing that savings can make a real difference in shortening the time required to reach the needed amount.
There are several government agencies that provide help to first-time and low income home buyers. These include the Federal Housing Administration, the Veteran’s Administration and state housing authorities. Each of these offers different programs that are designed to assist individuals in meeting down payment requirements and securing home loans. Before committing to any particular method, it is worth checking with each of these departments to ascertain if a program is available that may be utilized.
An alternate source of funds that may be used for the down payment on a home loan is one’s retirement account. Under provisions of certain retirement plans, it may be possible to borrow from these accounts or make penalty-free distributions in order to purchase a new home. For example, some 401k plans offer a 401k loan for a home purchase, up to $50,000. In addition, IRAs have a provision where you can withdraw up to $10,000, without penalty, for the purchase of a home.
Keep in mind that tapping into retirement funds may not be the best way to go about coming up with the down payment. After all, you’re just robbing Peter to pay Paul. But you at least want to know what options are available to you.
Maximizing Your Savings
Under the current financial landscape, there are limited options to maximize savings while keeping risk low. Savings accounts these days are obviously safe, but with that safety comes limited interest. Here are some current high-yield savings options. Another option may be CDs. If you’re specifically saving for a down payment on a house that will be a year or two down the road, then CDs may be a better option in order to earn a little more interest. Finally, if you don’t mind a slight element of risk and your home purchase is at least a few years out, you could invest conservatively in bonds or a bond fund.
No matter how you slice it, coming up with that down payment is an important aspect of buying a home. You will save money, build equity, and provide yourself with a little flexibility. Since coming up with a significant down payment usually doesn’t happen overnight it is equally important to begin planning for that future home purchase early and put your money to work the best you can.
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Filed Under: Real Estate
About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.