Buying With Less Than 20% down

Amassing a 20 percent down payment — or any sizable downpayment, for that matter — is difficult for most people. Saving money in general is difficult for most.

While a large downpayment can convey benefits (smaller loan balance, lower interest cost over time, no mortgage insurance premiums) the reality is that most borrowers are chasing the ever-moving goalposts, and the larger the percentage, the harder it can be to reach them.

By way of example, lets say that homes in your market are selling for $200,000. We’ll compare two borrowers — one who waits to accumulate a 20 percent down payment and one who buys with just 5 percent down.

A wannabe homebuyer starts to save money to amass a down payment. A goal of 20 percent is set, so the borrower needs to save up $40,000 in cash.

Even with diligent savings, accumulating $40,000 in cash will take some time. For our purposes, let’s say this takes two years. Great! Now they’re ready to look for a home.  But wait!  Home prices have risen by 5 percent in the first year (to $210,000) and have risen another 5 percent the second year, so the $200,000 homes they hoped to buy are now selling for $220,500. To maintain that 20 percent down payment figure, the potential homebuyer will have to bank another $4,100. This could delay purchasing again for a while, another couple of months at least.

Now consider someone who is only looking to make a minimum down payment — just to get a foot in the door, so to speak. While 3 percent down options are available, they shoot for 5 percent. As above, homes are selling for $200,000 and making a 5 percent down payment means amassing $10,000 in cash. In the same example of saving as above, this potential borrower was saving $1,666.66 per month; this means only six months of cash accumulation before they can move into the market to buy a home. As above, prices have moved upward a bit… but over this 6 month period, perhaps just 2.5 percent. This means they need additional savings of only $250 to cover the difference — or less than one week’s additional cash accumulation.

Let’s look at some additional figures, too. The buyer who waited to buy purchases a home for $220,500, and with 20 percent down, the home has a mortgage of $176,400 and no Private Mortgage Insurance (PMI). At a 4 percent rate, and with a 30-year term, this translates into a principal and interest payment of $842.16 per month.

The buyer who did not wait to buy purchases a home for $205,000 (that’s $200,000 appreciated by 2.5 percent over a six-month period). With 5 percent down, this leaves a mortgage amount of $194,750; with a 4 percent interest rate and a 30-year term as above, this would see a principal and interest payment of $929.77 plus an additional PMI payment of $95.75 per month for a borrower with very good credit, for a total payment of $1,025.52 per month.

So the borrower who bought sooner with a smaller down payment has higher costs. However, there are some compensating factors to consider.

To start with, the borrower who bought sooner has experienced some beneficial price inflation. Over the 18 month differential (when compared against the borrower who waited) the original purchase price of $205,000 has now moved up to a value of $220,631.25; coupled this with 18 months of paying down the loan balance ($189,552.34 after 18 months), this borrower’s equity stake has risen from 5 percent to about 14 percent (expanding from an original $5,250 to a current $31,078.91). It may only be a few additional months before they are eligible to cancel the PMI (generally this is a minimum of 24 months must pass before the lender will consider cancellation). When this occurs, their monthly payment will drop back to just $929.77, so their initially substantially higher costs end up only about $87 per month more than the buyer who waited. (We might recommend using the former $95.75 PMI payment as a monthly prepayment, which would produce tremendous additional interest savings over time).

Buying a home with a smaller down payment does have its costs, as demonstrated above. All other things being equal, a higher loan amount will carry higher monthly payments and total interest costs than will a smaller loan. The higher loan amount means that the borrower with the smaller down payment needs to have higher income to qualify, especially when PMI costs are considered, as they will be. That said, buying sooner means that the process of equity building can start sooner, and this is especially the case if home prices are rising strongly, as they have been in many markets for the last few years.

Of course, waiting to buy can have its costs, too. The opportunism provided by a smaller down payment means that a potential homebuyer can move more quickly to take advantage when a desirable property comes on the market; the borrower waiting for an arbitrarily higher down payment may miss this chance. If we consider these homebuyers to be first-time buyers, looking for starter homes already in short supply, it may be that the buyer who waits may have little to buy — or could possibly even be paying a premium to the buyer who bought sooner and may already be selling and moving up.

One additional caveat — wildcard, actually — is interest rates. While low and fairly stable in recent years, there is no certainty or guaranty that they will be the same in two years as they are today; in fact, it’s a good bet that they will be different. How much different is unknown, but even if the borrower who waited sees rates of only a half percentage point higher, the cost difference between the choices narrows considerably (especially after the PMI cost for the 5 percent down borrower is eliminated).