In October 2020, I wrote a blog post titled Why You Should Almost Never Choose a 15-Year Mortgage. The premise of the article was that you’re generally better off going with a lower-payment 30 year mortgage as it allows you to build more wealth. This post has garnered a lot of attention and a reader recently asked if the same concept applied to the amount of down payment a person makes. In today’s post, I tackle that question.
The reader was essentially asking, “Will your wealth be larger by putting down a smaller amount so that you can keep more of your money and invest it?”
Private Mortgage Insurance (PMI)
Before I answer that question, I need to discuss PMI. A general rule of thumb is to put down 20% so that you avoid PMI.
If you’re planning on getting a mortgage and put down less than 20%, the bank will charge you PMI, which ranges from 0.50% – 1.00% of the loan amount according to Rocket Mortgage. Some estimates reflect PMI being as high as 2.00%. On a $400,000 house with a $380,000 loan (at a 1.00% PMI charge) this would result in an extra payment of $317 / mo (($380,000 x 1.00%) / 12), above and beyond your loan payment.
Banks do this to protect themselves. If you default on your loan, then the bank only has to sell your home for 80% of its value to recoup what they lent to you (the other 20% comes from the insurance company).
A Smaller Down Payment or a Larger Down Payment – Which is Better?
Now back to the question at hand – “Will your wealth be larger by putting down a smaller amount so that you can keep more of your money and invest it?”
On the one hand, if you can afford it, it would be very attractive to put down 20% and avoid the extra monthly PMI payment.
On the other hand, you could make a much smaller down payment, pay PMI, and invest the dollars not used for a down payment.
Both options sound very good, but which is better?
Unfortunately I have to give you the dreaded “it depends” answer. There is no one right decision in all circumstances.
When to Choose a 5% Down Payment
1. Your PMI Will Not Be Very Expensive. If PMI costs 0.50% of the loan balance, instead of 1.00% or more, then it would likely be best to go with a 5% down payment (assuming that you earn at least 6.00% on your investment portfolio). PMI costs are influenced by your credit score, amount of down payment, type of loan, and mortgage amount. Be sure to ask your lender exactly how much your PMI will be based on your unique circumstances. They should be able to give you a fairly accurate estimate. If it turns out that your PMI is very low, then by all means, go with a 5% down payment and invest the rest!
2. You Won’t Have Any Cash Leftover With a Larger Down Payment. If you use all of your cash / savings for a down payment, then that would not be wise as a homeowner. You need cash to protect your from unexpected expenses or a job loss. Never go into home ownership without cash on hand. Aim to have enough cash on hand to cover 3 to 6 months of expenses.
3. A 5% Down Payment is All You Can Afford. This one is pretty obvious!
4. The Housing Market is Overpriced. Currently we are in a real estate bubble. Housing prices across the nation have been selling for far more money post-COVID. If you were to make a large down payment on a new home and housing prices revert to more normal levels, you could see your entire equity or down payment evaporate. If you are concerned about this, then go with a 5% down payment.
5. Diversification is Important to You. Making a smaller down payment such as 5% allows you to keep more cash on hand and invest it into many different things (i.e. stocks, bonds, cash, real estate, business, etc.). You generally reduce your risk by doing this. By contrast, if you put a large down payment into your house, then not only are you investing in one sector (real estate), but more importantly you’re investing in one property. That comes with a lot of risk – see point #4 above.
6. You Purchased Your House at a Significant Discount. This one is my personal favorite! If you bought a house at a discount then you’ve got built in equity. As such, you can make a 5% down payment and then have your house appraised later on for its true value (usually you have to wait at least six months from when you bought the house to do an appraisal, but check with your lender to find out). If your house appraises for enough to give you 20% equity [(value of house – loan balance) / value of house], then contact your lender to have the PMI payments removed. This allows you to keep more of your cash (and possibly invest it) and only pay PMI for a short period of time.
When to Choose a 20% Down Payment
1. You Can’t Afford the Monthly Loan Payment With a 5% Down Payment. A smaller down payment would result in a larger loan payment. And if you can’t afford that larger payment, you will be forced to go with a larger down payment. There are ways around this such as investing the cash you didn’t put down to help you make the payment, but that is a conversation for a different day.
2. Your Mortgage Interest is Higher Than Your Investment Return. If this is the case, then a 20% down payment is best. This is due primarily to the fact that a 20% down payment allows you save more interest than the return you would make investing with a 5% down payment.
3. You Won’t Invest Your Down Payment Savings. The concept is similar to #2 above. If you aren’t making any money on your investments, then at least make a large down payment to save mortgage interest.
4. Your Mortgage Loan Interest is 6% or Higher. Mortgage interest rates are still very low; however, it’s not unfathomable to think that they will rise in the future. The higher your loan interest rate, the more difficult it will be for your investment portfolio to overcome that. As a result, you will likely be better off by making a large down payment to save the loan interest. This will be a guaranteed savings.
As you can see there are a lot of factors at play and there is no “one size fits all” approach. You must consider your unique circumstances to determine which option is best for you. Also, keep in mind that this article is based on today’s 30 year mortgage rates which hover around 3.00% to 3.25%. If rates go up, then the information in this article will likely change.
I hope that you’ve enjoyed this article. Please comment below and share how you’ve handled down payments over the years? Do you prefer smaller down payments or larger ones? And why?
CERTIFIED FINANCIAL PLANNER™