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.
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 8-10% 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.
Why a minimum down payment of 20 percent is necessary
Many loan products in today's marketplace offer as low as 0% down when purchasing a home. For conventional loans, typically the buyer is required to put at least 5% down. Regardless, using anything below 20% as a down payment when shopping for homes is a big mistake.
The 20% Rule
Generally speaking, a 20% down payment should be the norm when purchasing your home. Here are some reasons to put as much as possible down on a home:
These are some of the most noteworthy reasons to put 20% down on a home. Mortgage interest write offs are a thing of the past and should not be a reason to borrow more money. Remember, large interest payments are the enemy of debt elimination. Having significant amounts of interest is indicative of high principal balance that is ultimately still owed. This is never a good thing for those on the path to financial independence.
However, there is still an even bigger reason to put 20% down on a home.
The single biggest reason to put 20% down payment
The most significant reason to put 20% down on a home is to keep you honest with your home search. If you stay within a price of homes that still permits a comfortable 20% down payment, it will prevent you from living above your means. Using 20% down is a an excellent way to figure out how much house you can truly afford.
As a general rule of thumb, I still like to have 6 months worth of savings in an emergency fund along with at least $2,500 in my checking account after making a down payment and closing costs. Working backwards to figure out how much you need saved would look something like this:
For example, say you have $3,000 a month in expenses and you are seeking to purchase a home below $275,000. Using the equation above, we can find out the minimum amount necessary to fund the purchase of a $275,000 home.
I would suggest that you never expect to use your emergency fund for anything related to a home purchase and closing costs. Do not earmark this money for anything except a true emergency. The extra $2,500 I recommend is to cover some minor expenses and repairs that you come across when moving into a home for the first time.
One look at the necessary minimum for purchasing a $275,000 home may leave you feeling like this is unattainable. If this is the case, you have two options. Option A is to lower your desired purchase price. Option B is to save up for longer because you are not ready to purchase this much home.
The safeguards of 20% down
Using the 20% rule as a metric for determining how much house you can afford would prevent the most common financial mistake of homebuyers, purchasing too much home. Further, by saving the necessary minimum amount highlighted in the equation above, you prove to yourself that you are financially prepared to make the largest purchasing decision of your life.
Be careful about listening to the advisement of those urging you to put no money down or using bizarre mortgage products such as interest only loans. Saving and preparing financially for a home purchase can be simple and straightforward, whereas using a more advanced strategy like an interest only loan or a 0% down payment can be costly and complex long-term. Nothing is more devastating in personal finance than debt and a mortgage will likely be the largest loan you will ever incur. Do not be afraid to purchase a home, but first make sure you are truly financially prepared by using the tips found above.
I started this blog because friends and family often asked me similar questions regarding personal finance. I was surprised just how much people were interested in improving their financial situation, yet had no idea where to start. It made perfect sense to start a blog and share all the information that I have learned along the way with others. You will find many resources and links referred throughout the blog. I have found all of this information useful and continue to grow my knowledge and understanding in the personal finance space. Admittedly, even I struggled heavily in the beginning with understanding how to improve my financial situation. The power of reading and note taking got me where I am today and will continue to provide a return on investment for years to come. I look forward to sharing with you along the way.