Investment Glossary – Down Payment
When most people make an offer to buy a house, they typically don’t have the full asking price of the house sitting in a bank account somewhere, ready to make that purchase. Some people do, and those people are incredibly fortunate to be able to do so. But if you are one of the many people who can’t afford to pay cash for a home, you are likely going to turn to a mortgage to cover the cost of the home. And one of the key factors that affects your mortgage payment, other than the mortgage rate and the purchase price, is the size of your down payment.
A down payment is the money you pay up front when you buy a home using a mortgage. Banks and other lenders can’t be on the hook for an entire home purchase worth potentially hundreds thousands of dollars, which is why they usually want to see borrowers with some skin in the game. For this reason, down payments are a key part of the mortgage underwriting process. Many home sellers also tend to look for buyers offering higher down payments since more money down tends to represent greater stability and a lower chance that a deal will fall through because of problems with underwriting a mortgage or someone’s decision to simply back out of a deal. With three parties typically involved in most home purchases (buyer, seller, and lender), higher down payments and a mortgage preapproval are signals to the other two parties that you are a serious buyer.
While there are some programs that require as little as 3.5% of the home price used as a down payment, such as Federal Housing Administration (FHA) loans, or Veterans Administration (VA) loans that don’t require any down payment at all, many lenders like to see (or even require) higher down payments in order to lend you money for a home. In fact, if you make a down payment of less than 20%, most lenders will require you to take out private mortgage insurance (PMI), which adds an additional cost to your monthly bill. You can eventually refinance out of PMI if you get to the point where your equity in the home exceeds 20% of its value, but this requires a refinanced mortgage, which may be difficult if your circumstances have changed since you took out your initial mortgage.
The size of your down payment can also have an impact on determining how much house you can afford since a larger down payment may reduce your monthly principal and interest payments. So while it may be difficult to save up for a larger down payment, it could potentially result in a greater pool of homes that are now affordable to you because you probably wouldn’t need to borrow as much money to afford them. You may be tempted to look at larger, more expensive homes if you are able to save more for your down payment, but having a lower monthly mortgage payment can give you a lot of flexibility for other purchases. A lower payment could also allow you to adjust other parts of your life, like reducing hours at your job or being able to take care of kids or grandkids instead of working as much as you would need to in order to cover any higher expenses.
If you’re someone who is looking at real estate as an investment, a down payment also has the potential to dramatically affect the returns you generate on that investment. Let’s use the example of a property worth $200,000. In this example, you are going to put 20%, or $40,000, as your down payment. If the property value rises by 10% and you go to sell (assuming you don’t use a broker and calculate everything before taxes), your $40,000 has now turned into $60,000. Likewise, if the property value falls by 10% and you go to sell, your $40,000 has now become $20,000. The fact that you borrowed money increases your potential return if the value rises, but it also makes the pain that much worse if values fall.
What if you put 50% down in that situation?
In that case, you are putting $100,000 down on the property. A 10% rise in the value would likely result in a $20,000 (20%) gain for you, while a 10% loss in value results in a $20,000 (20%) loss for you on the downside. Larger down payments may result in less volatility in your returns if you go to sell a property while the mortgage is still outstanding. On the other side of the equation, smaller down payments mean you are more susceptible to a high-percentage loss if the property value declines. In this scenario, you could look to use the amount of your down payment as a way to control your risk if you need to sell the property at some point.
First-time homebuyers often find that saving for a down payment is one of the most challenging things to do. You are talking about saving thousands of dollars and, in a lot of cases, you may see home prices continuing to rise during the saving process. It can take years to save up a down payment in expensive markets, so it might be worth exploring low down payment opportunities with lenders. However, it’s important to remember that larger down payments can typically give you more flexibility, both in terms of the houses available to you, as well as your ability to keep your monthly mortgage payments below the maximum you can afford.