Why You Need (Or Don't Need) a Down Payment

Why You Need (Or Don't Need) a Down Payment

I stumbled across this Kiplinger article this morning regarding why you need to have a down payment when you buy a home, and as I often do, I found some points that I disagree with. The article starts with this question:

My wife and I just got married and we’d like to buy a house soon. We’ve been setting aside money for the down payment but we have quite a way to go — we’d need about $70,000 to make a 20% down payment in our area. We’re wondering whether we should just go ahead and buy a house now with no money down or wait until we’ve saved the 20%?

Kiplinger points out the obvious and explains how lenders are making it increasingly easy to obtain 100% financing when purchasing a home. They then explain that by accumulating a 20% down payment you can avoid paying PMI which can run anywhere from about 0.5% to 1%, which is true. It also explains briefly how to piggyback loans to avoid PMI which has recently become a very common borrowing option, which as with PMI can be costly. Ultimately they stress why it is so important to save up that 20% before buying a home, which is where I disagree.

A blanket statement that says one should wait to buy to save 20% isn’t totally accurate given there are many different situations as well as many hidden opportunity costs that could be associated with waiting. But first, what are the advantages to saving up that 20% down payment? Obviously the biggest reason is instant equity and lowering the total amount you need to borrow. A home is a great asset and the sooner you have equity in it the better. Another issue which Kiplinger mentioned was eliminating PMI. This is important because that added cost can add up to $3,500 (on a $350,000 home in this example) over the course of a year which is not tax-deductible. Obviously it makes sense to put 20% down for these benefits as it can save a lot of money. But in this example, how long would it take for a young couple to save $70,000?

The ability to save this kind of money can take time, maybe three years or more depending on many factors. By putting off the home purchase you are betting on a few factors. First are interest rates. If you are simply trying to avoid PMI and save yourself 0.5% or 1% you are taking a bet that 3 or 4 years from now when you do have that money saved up that interest rates will be the same or lower than today. Who can predict rates that far into the future? What happens if rates go up 1% or 2% when you’ve finally saved up that down payment? Granted you will have initial equity and avoid paying a half or one point on PMI but you may end up paying the same if not higher rate if rates change.

The next issue you are betting on is the housing market in general. Will home prices go up, down or stay the same in a few years? You could be pleasantly surprised to find them decrease more so that your initial amount you planned on spending buys more house for the money, but you could also be disappointed that you waited because now the type of home or location you were originally looking at is out of your price range.

Third, what are you sacrificing now in order to save for the down payment? Saving that kind of money could affect your ability to continue contributing to your retirement accounts at the same level. I personally would say that if saving for a down payment reduces the ability to continue funding your retirement accounts or other important savings goals you should evaluate that decision very carefully. The money saved by eliminating PMI could be minor compared to the damage caused by reducing retirement plan contributions and the missed years of additional compounding that money could have seen.

Finally, in many instances I think this is a case of a bird in the hand is worth two in the bush. By continuing to rent that money is for the most part being wasted. It may be less than a mortgage payment, but what is it really providing other than a roof over your head? For example, lets say that it will take you about 3 years to save up your down payment. During that time you continue to rent, which is building 0 equity and has no tax benefits. When the time comes you buy your house and put 20% down, building equity and by avoiding PMI, reducing your payment by a couple hundred bucks over what it would have been otherwise. Not a bad scenario right? Well, what was potentially foregone by waiting to purchase?

Assuming interest rates are the same and the housing market hasn’t really changed you still could have missed out on many benefits even if you bought with a worst-case $0 down. First lets look at taxes. On the $350,000 mortgage in this example with a 6% interest rate you will pay roughly $20,800 in interest the first year, and just over $20,000 in the next two years. That $20,000 deduction will likely make the PMI you pay a wash or actually save you money come tax time (and I didn’t factor in property taxes because that can vary significantly). On top of the tax savings you are also building equity from the start at roughly $4,300 for those three years for a total of about $13,000 and that is if you are only paying the minimum each month. Yes, it is a lower number than 20% but you have gained a few things: a tax break that will nullify any additional money owed by not taking out 20% and not having to forfeit any savings towards things such as retirement.

Also, a home is an asset and its value can compound just like any other investments you may have. By purchasing the home three years earlier, and assuming your home increases at the rate of inflation each year (roughly 3%) your value will have increased by roughly $32,500 in that time. Of course these are unrealized gains and nothing matters until the home is again resold, but you can see the point.

Clearly buying a home is an important and difficult decision. There are far too many variables in play to simply say you need to wait and save up 20% just as you can’t immediately justify buying now with no money down. Many factors in your personal situation will dictate what would work best for you. As you can see though there are many reasons why waiting to purchase so you can have that big down payment may be an unfavorable option. Make sure you go through all of the options available when taking the plunge to purchase your first home.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

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