When Buying A Home, What’s the Best Down Payment? By: John Adams
TEASE: One of the largest barriers to homeownership is coming up with the cash you need to swing a loan. Realistically, the vast majority of us can’t just write a check and buy a house. But when we look into home loans, there is a dizzying array of down payment options.
Here are some of the questions I am most frequently asked:
Q: Why are we talking about down payment amounts? Does it really make that much difference?
A: Yes, it does. In fact, the amount of cash down payment you choose will have a dramatic effect on not only your interest rate, but on the overall terms of the loan itself.
Q: Let’s begin by talking about alternatives. What are my options?
A: In today’s market, you can select anywhere from 3% to 100% down as a cash down payment. The amount you select is deducted from the purchase price and the remainder becomes your loan amount.
Q: Wait a minute. Who pays 100% down for a house?
A: Mostly investors buying distressed properties and international buyers are the ones paying cash. In addition, about half of those buying a second home pay cash.
Cash sales are currently about 23 percent of the market.
Q: Do any first time buyers pay cash?
A: In 2017, barely 6% of first time buyers just write a check and move in.
Q: So, the rest of us need a loan. What are our down payment options?
A: Generally speaking, a down payment of 20% of the purchase price will earn you the lowest interest rate and best terms and conditions.
One common misconception is that if you can put down more, say 50% of the purchase price, you can do better somehow. Typically that is not the case.
In most cases, there is no additional benefit to borrowing less than 80% of the purchase price.
Q: Let’s just say I happen to have 50% in the bank, just waiting to be spent. Am I better off using it for a down payment?
A: That depends on your investment alternatives and your willingness to be disciplined.
On a hundred thousand dollar home, we are talking about ($50K cash vs $20K cash) thirty thousand dollars.
If you would leave the $30K sitting in the bank earning 0.1% interest for the next 30 years, then yes, you are better off using that money to avoid being charged an interest at a rate of say 4%.
But if you invest the money in a safe long term mutual fund, you can likely earn 7% to 10%, and maybe more over an extended period of time. So it’s really up to you.
Q: Now, let’s get back to reality. What about the rest of us who don’t have a rich uncle?
A: Well, you still have plenty of alternatives from which to choose:
- 10% down is the first level of home lending that usually requires private mortgage insurance, often called PMI.
- FNMA and Freddie Mac guarantee most loans only up to 80% of a home’s appraised value. Lenders must take a risk when they loan more than that, so they take out an insurance policy, and let you pay for it, month after month. It’s commonly called PMI.
- PMI typically costs between ½% and 1% of the loan balance on an annual basis. On a $200,000 loan, that could amount to almost $170 monthly. And it’s not even tax deductible.
- The next level of 5% down, and that is the smallest down payment you will find on a conventional loan. At this point, your credit score needs to be 720 or higher, and you need to have a stable job history. Expect a higher level of scrutiny by your lender when applying for this loan.
- Finally, if all you can scrape together is 3.5% of the purchase price, the FHA is here for you.
- FHA routinely makes loans up to 96.5% of your home’s appraised value IF you jump through all their hoops and IF your credit is solid. Earlier this year, FHA reduced their PMI charge from 0.85% annually to 0.6% annually.
- As a result, FHA loans are more competitive with conventional loans than they have been in several years.
Q: So, which down payment is best for me?
A: Usually, it’s the highest one you can afford, up to 20% cash down.
Because interest rates are so low, I don’t see any benefit to tying up extra cash in your home when you could use that money more wisely earning a better rate of return over many years.
Q: But isn’t there a significant risk in hoping for a good investment return?
A: Yes, but there is also a significant risk in getting out of bed every morning.
The bottom line: If you are smart enough to buy and own a house, you are smart enough to get good advice from an unbiased source and invest your money wisely.
If you’d like to know more about down payments and PMI insurance costs, I’ve put together a fact sheet available as a download from my website at Money99.com. Just click on RESOURCES.
Atlanta native John Adams is a broker, broadcaster, and writer who owns and manages residential real estate in the Atlanta area. He answers real estate questions on his award winning internet radio show every Saturday at 10 a.m. on Money99.com. You can contact John through his website at Money99.com, where you will find additional information on this topic.