Why “You Need 20% Down” is a Myth: The Pros and Cons of a Buying a Home with a Low Down Payment
We’ve all heard it before: Before you can take the leap into the housing market, you need to start saving up to make a sizable down payment. For years, putting down 20% of a home’s purchase price was held up as the gold standard. While many still consider this figure to be their goal, rising housing prices are causing others to look for alternatives.
Ultimately, only you and your financial advisor can decide on the best path for you to take. However, we’re here to let you know that it is possible to become a homeowner with less money upfront. Below are the pros and cons of a buying with a low down payment (you can secure a mortgage with as little as 3.5 percent). Read them over to help get a sense of whether or not it’s the right move for you.
PRO: Your Monthly Payments Build Equity
Whether you’re renting or buying, you’ll need to make a monthly payment towards your housing costs. The difference is in who sees the benefit from it. On the one hand, if you decide wait on buying, keep in mind that a substantial portion of your income will need to go towards rent payments. This may slow down progress towards your savings goals and, at the end of the day, your landlord is the one who makes a profit off your hard work.
On the other, when you make a mortgage payment, that money helps build equity. (For those who need a refresher, equity is a fancy word to describe the portion of your home that you own outright. It’s determined by taking the home’s current market value and subtracting the amount you have left to pay on your mortgage.) As you make payments and lower what you owe, your asset becomes steadily more valuable.
CON: You’ll Face Higher Interest Rates
Any time a bank gives someone a home loan, they take a risk. There’s always a chance that the borrower will stop making mortgage payments and the bank won’t be able to recoup its initial investment. As a result, they take precautions to protect their investments and one way is in the form of interest rates. The offer varying rates based on certain they are that the loan will be repaid.
Having a sizable savings account is an indicator that someone is financially stable enough to keep up with regular mortgage payments, so buyers who make high down payments are often offered the lowest rates. Conversely, if you opt to put less money down, you can expect a to pay more in interest, which will lead to a higher monthly payment.
PRO: You Can Refinance Sooner
That said, your first mortgage probably won’t be your last. As the value of your home increases — either through rising property values, substantial improvements, or by paying down the mortgage — you’ll have the chance to refinance. When you refinance, you simply take out a new home loan to pay off the remainder of the original. Doing so will save you money in the long run because you’ll be taking out a smaller loan and will often be given a lower interest rate.
Most lenders won’t allow you to do this at least until two years after your original purchase. However, if you make your payments diligently and take care of your home, those interest rates won’t be an issue for long.
CON: You’ll Have To Pay Mortgage Insurance
Another way banks protect themselves against defaulted loans is through private mortgage insurance, or PMI. Many lenders require that anyone who buys with less than 20% down take out a policy. Even though you’re responsible for paying the premium, your bank will receive the payout, in the event that you stop paying your mortgage. Buyers who are able to make a larger down payment usually aren’t subject to this requirement.
Obviously, this cost will also need to be factored into your monthly costs, if you decide to put less money down, but it won’t last forever. Banks are required to end the policy once you’ve gotten your mortgage down to 78% of the purchase price (and some may end it at 80%, if you take the initiative to ask). Depending on how and when you refinance, you may also be able to secure a new loan without the PMI requirement.