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Ask Brian: Is Buying a Home with Less Than 20% Down Wise?

By Brian KlineFebruary 02, 2022
  • Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].

    Question from April in Raleigh NC: Hello Brian. I’ve heard of the 20% down payment rule, but I also understand this is mostly a myth because most people have a much smaller down payment. But it does leave me with a couple of questions. Where does the 20% down payment rule come from? Is buying a home with less than 20% down wise?

    Answer: Hello April. A slightly different version of your question might be more helpful. I suggest asking, “When does it make sense to put less than 20% down on a home?” But I’ll start with your first question about where the 20% rule comes from?

    April, you’re correct that the 20% down rule is a myth. However, it is pretty much a rule if you want to avoid private mortgage insurance (PMI) on a conventional loan. There are a few things to know about PMI. First, it is not cheap. The amount varies but is typically between 0.5% – 1% of your loan amount per year. On a $300,000 mortgage that amounts to between an extra $1,500 – $3,000 each year. The second major point to understand is that PMI is NOT insurance for the homeowner. It is insurance for the mortgage company. It protects your lender if you stop making payments on your loan. But it does nothing to prevent foreclosure or to protect your credit rating if you stop making the mortgage payments. As a homeowner, you are paying for something that has no benefit for you other than allowing you to qualify for a mortgage with less than a 20% down payment.

    That is the main reason why it makes sense for a 20% down payment but there are others. The other reasons don’t have to be the full 20% but the benefits increase as the amount of the down payment increases. To start with, the higher the down payment, the lower your loan-to-value ratio (LTV). This is a key ratio for lenders because it lowers their risk for making the loan. The lower risk can mean a lower interest rate for the home buyer and possibly avoid some other fees that show up at closing.

    That same lower LTV is going to make it financially easier on the home buyer after the purchase is completed. A lower LTV means the buyer has more cash left over to spend on other things each month after the mortgage payment is made. That is because the monthly mortgage payment will be less when less money is borrowed.

    Another time a larger down payment is helpful is if there is a bidding war. This starts when the seller is first considering the offer. A larger down payment strengthens your offer because it assures the seller that you're on solid financial ground and your financing is likely to go through. And it goes further in a bidding war if the appraisal is for less than the sale’s price. Lenders will not approve a loan for more than the appraised value. But the buyer can still pay more than the appraisal if they have the cash. The higher the down payment, the more cash the buyer is bringing to the deal. It’s possible that the down payment will cover the sale’s price amount that is above the appraised amount. The lender can still approve the loan if the loan is for less than the appraisal.

    So April, the 20% down rule only applies if you want to avoid the PMI on a conventional loan. However, there are several very good reasons to make a large down payment. Typically, people that already own a home and will be using the equity that they have in that home as a down payment on a new home. Second time buyers often make a 20% or larger down payment on the new home. It’s first-time buyers that typically have a down payment of less than 20%. In fact, most people do not put down 20%. According to a 2021 National Association of Realtors report, 52% of mortgage borrowers put down less than 20%. When it came to first-time buyers, that number jumped to a whopping 74%. Here are some of the most common reasons why home buyers put down less than 20%.

    • Making a down payment of less than 20% allows you to buy a home sooner and begin building equity sooner.
    • Less money down reduces your long-term financial risk. Once the money is sunk in a down payment, it is gone. It is no longer available as an emergency fund if an important need for money happens. Rebuilding an emergency fund after buying a house can take a long time because of the added expenses that homeowners have.
    • Less money to make repairs or upgrades. This can be particularly important to buyers that buy a “fixer” home. It requires cash to make repairs and take care of neglected maintenance. It can also delay the plans for someone buying an outdated home needing significant remodeling. Or even for someone that wants to buy more furniture for additional space they now have. Or for appliances that you didn’t need as a renter such as a lawnmower or a washer and dryer.
    • The opportunity cost of saving 20%. When home prices are appreciating at a fast pace, it takes longer to save a large down payment. Getting into a home sooner is an opportunity to start building equity that comes with the appreciation.
    • Some people want to leverage their cash in an appreciating market. For instance, if you buy a $300,000 house that increases 5% in value or $15,000 the first year, an all-cash purchase only increases your personal net worth by the same 5%. If you put 20% down, your net worth increases 25% on your $60,000 down payment. If you put 5% down, you’ve made 100% on your $15,000 down payment.
    • Even if you have the 20%, there may be better uses for some of the money such as adding to a retirement account or saving for a child’s higher education.
    • PMI is not forever. Something to know about PMI is that you can stop paying it once your equity reaches 20% -25%. In a fast-appreciating market, you will probably be able to stop paying the PMI in a couple of years.
    • You have an urgent need to buy a house as soon as possible. An example is that you are pregnant with twins and living in a one-bedroom apartment. Your need for more space might outweigh the financial benefits of saving a larger down payment.

    Yes, April, a 20% down payment is a myth. But now you understand the common reasons when it is smart financially and when a smaller down payment makes more financial sense. Here are the general down payment rules that you should know about for the most common mortgages:

    • Conventional Loan (with PMI): 3% minimum.
    • Conventional Loan (without PMI): 20% minimum.
    • FHA Loans require as little as 3.5% down.
    • VA Loans have no down payment requirements.
    • USDA Loans require nothing down.
    • Fannie Mae HomeReady Loan: 3% down minimum.
    • Freddie Mac Home Possible: 3% down minimum.
    • Jumbo Loan: typically 10% down, depending on the lender.

    It all comes down to personal situations. Sometimes it does make sense to put down 20% but for others, it makes better sense to make a smaller down payment.

    What can you add to the reasons to make a 20% down payment or to make a smaller down payment? Please share with a comment.

    Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].

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