It is common for homebuyers to purchase homes with minimum down payment loans. 5% down, 3% down and 0% down have become popular, especially with first-time homebuyers. But if you’re interested in achieving financial independence, you might want to rethink minimum down payment loans. This is even more important than the question of taking a 15 or 30 year mortgage.
By making a 20% down payment on a house, you open up all kinds financial benefits that will help you in buying your home, and keep your payment to a minimum when you do. Consider some of the benefits…
1. Protection against price declines
We discovered in the last recession – just in case we didn’t already consider the possibility – that property values can fall as well as rise. As a result, millions of people were stuck in homes that they either couldn’t afford to keep(due to a job loss), but could not sell, because the value of the property fell below the outstanding mortgage balance.
For many people in this predicament, the situation was either caused – or made worse – by a minimum down payment made at purchase. A down payment of 5% or less leaves you completely exposed to even small declines in house prices. For example, a 10% price decline can put a homeowner with a 5% down payment into a negative equity position immediately.
By making a 20% down payment, you will minimize both the likelihood and the severity of a price decline to put you into a negative equity situation.
2. Eliminating the need for mortgage insurance
When you make a down payment of less than 20% for a conventional loan, the mortgage lender will require that private mortgage insurance be added to your monthly payment. This can represent a substantial increase in that payment.
For example, the mortgage insurance rate on a 95% loan (5% down payment) is .94% for 30% coverage with a 700 credit score. That works out to be about $157 per month – or $1,880 per year – on a $200,000 mortgage loan.
By delaying your purchase until you have enough money to make a 20% down payment, you eliminate the need for mortgage insurance and keep your payment to a minimum.
3. Keeping the mortgage payment low
A larger down payment will mean a smaller mortgage amount, and the smaller your mortgage amount, the lower your monthly payment will be. If you’re purchasing a home for $250,000, and you make a 20% down payment, your loan is $200,000. At 4%, your monthly payment will be approximately $955.
But let’s say that instead of making a 20% down payment, you opt for a 5% down payment. Your loan is now $237,500, and because the larger loan size, your monthly payment rises from $955 to $1,134 – an increase of $179 per month.
But we’re not done yet.
Because you are putting down only 5%, you’ll be taking a 95% mortgage, and that will mean that mortgage insurance will be required. At .94%, your mortgage insurance premium will add $186 to your monthly payment. When you add the monthly mortgage insurance to the increased mortgage payment, you will pay $365 per month more than if you made a 20% down payment. That’s an extra $4,380 per year.
4. Getting the best rate and terms on the mortgage
Another factor that is not reflected in either of the calculations above is the fact that you will get a better rate and better terms as a result of making a 20% down payment. If you need a mortgage and you have bad credit, this is even more important.
Mortgage loans are based on “tiered pricing”, which is to say that your rate increases with the number of risks that your loan contains. One of the major risk factors in any mortgage is the loan-to-value ratio – the amount of your mortgage divided by the value of the home you’re buying. Loans with a down payment of 20% or greater get the best rate and terms. A smaller down payment will require that the rate you will get will increase, and the loan terms may be a bit stiffer.
The 20% down payment puts you in the range to get the best rate in terms available.
5. Greater likelihood of mortgage approval
Let’s step away from numbers for a bit. Making a 20% down payment on a home is a sign of borrower strength. Not only are you making a larger down payment, but the fact that you can do that is an indication that you have an ability to save money. That is one of the best indicators of borrower creditworthiness.
The 20% down payment simply means that you will have greater likelihood of being approved for a mortgage at all. Many borrowers have one or two credit risks in their profile; but a down payment of 20% or more is often considered to compensate for weakness elsewhere. Making a larger down payment can even be the difference between getting a loan approval or a loan decline.
6. Ability to pay off your mortgage faster and easier
Ultimately, it should be the goal of every homeowner to pay off the mortgage on their home early. Not only does it make good financial sense, but it’s also one of the single best preparations you can make for retirement. A mortgage-free home results in a significant drop in monthly expenses, and that will give you more flexibility when you retire.
It should go without saying that it will be easier to pay off a mortgage that is equal to 80% of the value of your home, rather than 95%. If nothing else, the monthly payment is smaller on the 80% loan, and you will be able to make a far greater amount of extra principal payments. That can make the difference between paying off a 30 year mortgage in 15 years, or having a ride out the entire loan term because you took a minimum down payment loan.
The benefits of a 20% down payment may be well worth the wait until you have the money to make it happen. How much would you put down today on a home purchase? Why?