Do I Really Need a 20% Down Payment?
My last post discussed the wonders of using the 20% rule as a guiding principal for determining a purchase price of a house. Now it's time to investigate the flipside of this argument.
Practically speaking, the 20% down payment rule on a house is mostly meant to serve as an affordability indicator. There will be many times however when a full 20% down payment is unnecessary and borderline dangerous.
As you will see at the end, I still believe in having at least 20% down in cash reserves or paper assets as a starting point. Once you have the 20% saved, only then can you make a decision if any of the exceptions below actually apply.
Exceptions to the 20% Rule:
1. If you have significant repairs to make.
If you believe you will have significant costs associated with renovations or refurbishment of existing structures, consider that having additional cash on hand might be better off. When mortgage rates are low, it makes more sense to avoid paying more interest for a construction loan. Keep in mind that construction loans seem to run around 1% higher than the prevailing mortgage rates over a given time.
2. If you anticipate needing cash for a large event.
Paying for your own wedding? Perhaps putting 20% down is not such a great idea after all. You will want to have additional cash on hand for flowers, décor, and whatever else comes your way.
3. If you are living a F.I. lifestyle
In this case, eliminating a significant amount of your capital might hurt your overall rate of return. If you are expecting an 8% yield from the stock market, then why take this money out of the market and put it into a house that typically only increases by 1% in value per year after inflation? If mortgage rates are high, this might make sense. But if mortgage rates are low (3% as of this writing), then you are likely better off leaving your money invested long-term in index funds.
4. When your mortgage payment is still less than 25% of your take-home pay with less than 20% down
If you made a sensible purchase, and after only 5 or 10% down you still have a mortgage payment less than one-quarter of your after-tax household monthly pay, then I admit you have some wiggle room. You should never, and I mean never, use this formula to purchase more house than you can afford. In other words, don't put less than 20% down just to purchase a home that is more expensive.
5. If you value having months or years worth of expenses saved in cash over equity in your home
This one is self explanatory. Would you lock all your hard earned savings into a home in the form of a down payment or have several years worth of expenses saved in a cash account. Put differently, would you rather have $60,000 in home equity via a down payment or 2 years worth of living expenses saved up in cash (assuming $3,000 a month in expenses)? The choice is yours.
How to decide how much to put down
I still suggest saving at least 20% down of your expected purchase price in cash. After that, you can decide if you want to put more or less down based on the criteria above.
Utilizing the 20% rule allows you to keep your purchase price realistic when shopping for a new place to live. It also demonstrates that you have the ability to save money consistently and diligently. It is a valuable rule to live by, yet can be flexible once you have attained it.
Leave a comment below if you believe you have another valid different reason to save less than 20% down.