For borrowers receiving advice from their parents, it’s probable they are hearing about the benefits of making a 20 percent down payment to purchase a home. The conventional wisdom says that making a large down payment is an effective strategy for decreasing risk since it reduces the size of the monthly payment.
Conventional wisdom also states that the road to hell is paved with good intentions. No offense to anyone who operates under the notion that a 20 percent down payment is the best way to finance a home, but good intentions can sometimes result in misguided advice, based on a lack of knowledge about the facts.
Of course, the only way it was possible to purchase a home for many years was to put down 20 percent. That is simply not true anymore. There are many loan products available now that allow for a down payment that is much smaller than 20 percent:
- FHA loans: 3.5 percent minimum down payment
- VA loans: No down payment required
- HomeReady™ loans: 3 percent minimum down payment
- Conventional loans (with PMI): 3 percent minimum down payment
- USDA loans: No down payment required
- Jumbo loans: 10 percent minimum down payment
Many folks with the requisite funds can become irritated when you try to point out that it may not be in their best interest to make a 20 percent down payment. An objection that I often hear is this: “I don’t care that there are other products out there Patrick! I’m putting down 20 percent so that I can decrease my overall costs.”
It’s true that a sizable down payment can reduce the overall costs associated with purchasing a home. However, the risk of having so much “skin in the game” far outweighs the benefits.
Putting down 20 percent can vastly reduce a home’s potential return on investment. Consider the example of a home purchased for $400,000, in a real estate market appreciating at the national average of 5 percent. Understanding that the home will be worth $420,000 in a year’s time, it’s easy to see how a down payment can impact return on investment.
With a down payment of $80,000 (20 percent), the rate of return on the $20,000 of appreciation is worth 25 percent – not too shabby! If the borrower had chosen to only put down $12,000 (3 percent), however, the rate of return would be 167 percent
Moreover, once a large sum of cash is applied to a down payment it is effectively gone and no longer available for emergencies. Since the funds are tied up in the home and no longer liquid, it can take time to regain access to them. A standard refinance can take a minimum of 21 days; selling a home can take much longer.
In the case of a sagging economy or declining real estate market, it is much riskier to make a sizable down payment. If the same home from the example above were suddenly worth just $320,000, the borrower who had opted for the smaller down payment would have only lost $12,000. The borrower who put down $80,000 had much more risk exposure. What’s worse is that in the event of a foreclosure, the banks would pursue the borrower with the larger equity position, since the sale of the home would show as a smaller loss on their books.
This article doesn’t take into account the fact that the $68,000 difference in down payments from the scenario above could be applied toward other investments with greater liquidity. For more information about why a smaller down payment is an effective strategy for limiting risk, please contact me at the number below.
Patrick Stoy (NMLS Numbers 39527 and 39166) has 16 years of mortgage lending experience. Patrick is CEO of Wilmington-based Market Consulting Mortgage, which he started in 2005 with a mission to build lifelong customer relationships by providing real value. To learn more about Marketing Consulting Mortgage, visit www.macmtg.com. Patrick can be reached at [email protected] or (910) 509-7105.