Large or small down payment?

You’re sitting across from a mortgage lender trying to get pre-approved and they ask you “how much do you want to put toward a down payment on a home?” you freeze for a moment and think to yourself “I never really thought about it, why did it matter anyway? Are there actually pro’s and con’s? I’ve heard 20% down is standard, so maybe I’ll just do that” 

You snap back to reality, and confidently tell your lender that 20% is fine, but for a split second you think “did I make the right choice?” 

Well, let me break it down for you

Let’s take a step back and define what a down payment is for those that don’t know. A down payment is a payment you make to purchase an asset such as a home or a car and is typically an out-of-pocket expense pulled from your personal savings. This payment is not borrowed and it’s main purpose is to reduce the risk for a lender to give you all this money and to make sure you’re competent enough to pay back the loan. 

Keep in mind that your down payment plays a crucial role in determining your loan to value ratio, which is calculated by dividing the loan amount by the home’s appraised value. This ratio might not seem very important to you yet, but understand that lenders use it to price your mortgage. The more you put down on the home, the lower the ratio will be. If the ratio is higher (exceeding 80% because you put less than 20% down) you’ll have a higher interest rate, if the ratio is lower, you’ll have a lower interest rate. 

As I mentioned in a lot of my other videos, if you put less than 20% down on a home you’ll have to pay private mortgage insurance, which is typically based on 0.5-1% of your loan balance per year. Your credit score, loan type and other factors will influence the PMI amount.  

The industry standard that was branded on everyone’s brain is you have to put 20% down. Well, I’m here to confidently tell you that 20% down payments are dead, as most people don’t put that much down on a home anyway. The median average is 7% down, and the average for repeat buyers alone is 16% down. 

Even with that statistic, according to Nerdwallet’s home buyer report, 62% of Americans still think you need at least 20% down on a home.. So believe me when I say there’s a reason realtors and other mortgage lenders create awareness about this, because everyone still believes it!

You don’t need 20% down to purchase a home, let’s say it together, you don’t need 20% down to purchase a home.

Now that we got that out of the way, your next question might be along the lines of “How much money should you put down on a home?” Let me answer this by providing you with pro’s and con’s of putting a smaller or larger down payment on a home.

Couple relax on the beach enjoy beautiful sea on the tropical island. Summer beach vacation concept

Starting off with the pros of a smaller down payment, when you put down a larger down payment, most people would be draining their savings accounts entirely, so putting down less will leave you with more funds to put toward home improvements, repairs that need immediate attention, emergency reserves, vacations and adventures or even investments you want to allocate more money to. 

This is by far the biggest pro for a smaller down payment especially for a first time home buyer who wants to have some money for closing costs, homeowners insurance, property taxes and new homeowner items like an awesome $3,000 zero turn lawn mower that’s definitely a necessity! You’ll also have the opportunity to buy a home earlier on, instead of taking extra time to save for a large down payment. So if time isn’t on your side this may be a point to heavily consider. 

When you think of homeownership, you think about equity, and with that comes the biggest con about a smaller down payment, and that is the lack of immediate equity. If you’re putting a smaller down payment down, make sure the home you’re looking for can suit your 5 year plan and beyond, because if you sell before then, you may not be able to cover the expenses to sell your home unless it’s in an area where homes are appreciating rather quickly. 

As I mentioned before, if you aren’t putting 20% down you’ll have to pay PMI until you hit 20% equity in your home. The most common way to pay PMI is monthly and made part of your mortgage payment, this added expense is definitely one of the negatives about homeownership especially since it’s very much contradicting. PMI does absolutely nothing for a buyer, and is simply insurance for the lender for the possibility you default on your home loan. So you’re being charged more in case you don’t have money to pay for your loan. Seems a little backwards doesn’t it? But understand that of course there’s going to be risk for anyone lending out that much money. 

Another con is the potential to have a higher interest rate. I said the potential because there’s a lot of factors involved to determine interest rate such as location, credit score, loan term, type, and down payment of course. A smaller down payment also leads to a higher monthly payment, as  larger down payment means a smaller loan amount, which then leads to a smaller monthly payment.

Lastly, the size of your down payment affects your offer on a home and whether or not it gets accepted. Especially in today’s market, where multiple offers and bidding wars aren’t uncommon, having a sizable down payment let’s the seller know you’re truly a serious buyer that doesn’t want to mess around and gives them confidence that you’ll get to the closing table without any financial issues. 

Let’s transition over to the pro’s of a larger down payment. As I mentioned before it will be a smaller monthly payment and you’ll be able to avoid private mortgage insurance when you have 20% equity in your home, You’ll also have the potential to get a lower interest rate, reduced closing costs, and if your credit isn’t the best, a larger down payment can help a lender approve you easier. You’ll also have more equity in your home so you can sell on a shorter notice without worrying about breaking even. If you’re shopping around for a mortgage and can have a larger down payment, lenders will be more likely to compete for your business as you’ve made it obvious you are a serious and non-risky buyer. 

When it comes to the cons of a larger down payment, it’ll take a lot longer to save, your savings account could be emptied without the creation of an emergency fund. It would be terrible to move into your new home and you don’t have additional savings to cover the cost of the furnace or A/C if they so happen to die on you. 

Another con that a lot of people aren’t talking about is the ability to deduct interest on your annual tax return. With mortgage rates low right now, it would be more beneficial to take a smaller down payment and invest those funds elsewhere. 

Lastly, a con to truly consider is the possibility of homeowner equity decreasing. Property prices can fall for numerous reasons, such as construction happening near you, they just put a strip mall across the street, or maybe the market crashes, you truly don’t know what the future holds and your decision made about doing a smaller or larger down payment can have you contemplating what if statements for days on end. 

My closing thoughts about whether or not to put a large or small down payment on a house depends entirely on the market. If you have an abundance of funds, and you can afford to put 20% down while having some leftover cash for all the other things I mentioned, then by all means do it. 

You’ll be able to avoid paying private mortgage insurance and you can lower your interest rate. If you take a look at your amortization schedule which is your payment schedule throughout the term of your loan, you’ll notice how the interest is a fairly significant part of that payment. You may also notice that they frontload the interest at the beginning of your mortgage payments, because lenders and banks understand that on average people move after 7 years and don’t stay for the full term of the loan. So putting more down on the home will reduce the overall amount of interest you have to pay for the life of the loan. 

On the other hand. If interest rates are already low, and you can put less down on the home and make your money work for you by putting it in stocks and other investment funds. Since the stock market yields a 8% return annually, it’s most definitely not a bad place to put your money. If you don’t have a lot of funds laying around, don’t stretch yourself thin by putting 20% down, because all it takes is a major appliance in your home to fall apart and you don’t have the money to cover it. 

There’s no doubt that your down payment plays a huge role in the home buying process, there are many pro’s and con’s for each option, so it’s very important that you understand each point and match it with what’s best for you and your situation. If you’re still unsure what option is best for you, feel free to reach out to me anytime and I’d be more than happy to talk it through with you and get some insight from a reputable mortgage lender to help your decision. 

Cheers,

Andrew McManamon

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