Downpayments: Why 20% is the Magic Number for Home Purchases

 
Richard Davey  CPA, CFP®

Richard Davey

CPA, CFP®

Trevor Scotto  CPA, CFP®, CDFA  ®

Trevor Scotto

CPA, CFP®, CDFA

®

 

Remember learning about how much money you should put down when buying your home in high school?  Me neither. Wouldn’t it be nice if someone would just tell us what the right amount is? Here are a few reasons that we recommend having at least 20% as a down payment.

1. You will avoid unnecessary fees

Private Mortgage Insurance (PMI) is insurance that is solely intended to protect the lender in the case you can’t keep up with your mortgage payments, but you are the one required to pay for it. PMI is usually thrown into the total costs of the mortgage when you, as a lendee, put in less than 20% of the down payment.  

This is important for you to know about because PMI could be costing you hundreds of extra dollars each month to buy your home without any tax advantages (or benefit to you). Many Americans pay PMI each month, but that doesn’t mean you have to.

On average, PMI costs around .5% to 1% of the loan amount. This means that for a $400,000 mortgage, you could end up paying up to $400 extra a month, just to protect the mortgage lender. We would prefer this cash go to your retirement/emergency fund or even your leisure fund.

Note that these extra PMI payments typically terminate when the equity in your home reaches 20%, but not always. In some cases you can get your PMI waived, but we would still recommend being cautious about moving forward with that kind of arrangement, as we’ll expand on in point #3.

2. Potentially qualify for a lower interest rate

If you put 20% down, you have a lot to lose in a bank foreclosure if you miss your payments. Because you have put a good chunk of the value down as a payment, the lender will likely offer you a better rate knowing you have a lower risk of missing payments and walking away from the house entirely (foreclosure) vs. someone who is only putting down 5-10%.

Even a small reduction in your interest rate can go a long away. For instance, a $500k 30 year loan with a 4.75% interest rate incurs ~$23,500 in interest expense in the first year of the loan. That same loan with a 4.25% interest rate incurs ~$2,500 LESS interest. That’s $2,500 staying in your pocket vs. going to the bank.

3. Reduce your chances of buying “too much home”

Every dollar you borrow increases your mortgage payment which increases the chance of being overextended in your home budget. Lenders prefer the 20% down payment because it shows the buyer is serious about the home and their intention to stay in it while making timely payments. After all, if you buy a $500,000 home with a $100,000 down payment, you are going to fight tooth and nail to make timely payments to avoid putting your $100k down payment at risk. If you only put 3% down ($15,000) there is less incentive to keep up when times get tough.  

It’s usually a good rule of thumb to avoid acting in a manner that would characterize you as a “high default risk” buyer in the eyes of the bank. If the bank would classify you as “high default risk” for putting down less than 20%, you should probably take that personally. Do YOU want to put yourself in a position of high default risk? After all, foreclosures are horribly damaging to your credit score and ability to borrow in the future.

The bottom line is this, the next time you are looking at your next home, make sure you have enough to afford at least a 20% down payment. 

 

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