How Much Should Your Down Payment Be?
I just recently became a homeowner and have been thinking a lot about my purchase. I published and article looking at whether it was better to own or rent. Though I should’ve looked at this before we purchased our home, luckily I found out that it was a financially better decision for us to own than to rent since we’re planning on staying in our home for the foreseeable future.
While I was working on that article, I found that your down payment is part of the equation to determine which option is better for you. I thought it made perfect sense to put a larger down payment, but the numbers I found made me think Kelsey and I made a mistake with our down payment. Let’s take a look at what factors you should consider when determining what your down payment should be.
Regardless of your down payment, if you stay in your home long enough, it’s better to own than to rent. But how much better and how long it takes to become better to own is highly dependent on your down payment.
First, let’s clarify what we’re talking about. If you’re going to finance your home purchase with a mortgage loan like most Americans, you’re going to need some sort of upfront payment to provide to your lender. This upfront payment is your down payment. Depending on your situation, you may qualify for some $0 down payment loans such as a Veterans Affairs loan for past military members, a USDA loan for purchases in more rural areas, or a Federal Housing Administration loan as a first time home buyer. If you don’t qualify for any of the mentioned programs, you’ll likely need at least 3.5% of the home’s purchase price specifically for your down payment.
Your down payment is going to play a factor into whether or not you get approved for the loan and what rate you get approved for. A higher down payment shows the lender that you’re able to make good financial decisions and therefore will be more likely to pay back your loan in the future. Generally a higher down payment results in getting a lower rate. A down payment of 20% of the purchase price will get you the best rate.
On the other hand, a down payment of less than 20% will have a higher interest rate. On top of that, you’ll have to pay Private Mortgage Insurance, or PMI. PMI is the lender’s way of protecting themselves in case you’re not able to make payments in the future. It’s typically about 1% of the loan amount annually, paid as part of the monthly mortgage. For a $250,000 house with a 4.25% loan, a $50,000 down payment results in a monthly payment of $1,013. If you scale that down payment back to $10,000 and add in PMI, your monthly payment jumps to $1473, $200 of which is going towards your PMI and not your loan.
So a higher down payment is better right? You don’t have to pay PMI, you get a lower monthly payment, and you pay less interest overall. I thought it was a no-brainer. Then, while I was writing last week’s article, I found some unexpected numbers showing up when it came to the down payment. When looking at renting vs. owning, you have to own your home for a certain period of time before it’s cheaper than renting. We’ll call this the break-even point. If you’re going to stay in a place for fewer years than the break-even point, you’re better off renting. If you stay in a place for more years than the break-even point, it’s cheaper to own.Turns out if you keep everything else equal, a larger down payment results in a break-even point farther in the future. For a $250,000 house, after accounting for closing costs, maintenance, inflation, and even opportunity costs, your break-even point is 4 years with a $10,000 down payment. But if you have a $50,000 down payment instead, it becomes 6 years!
So I thought to myself, “why in the world would a larger down payment push out the break-even point?!”. I found that the opportunity cost of putting your money into your down payment instead of investing really takes a toll. In our rent-or-own comparison, gains from using $10,000 to invest while renting are greater than the savings from using that same amount as a down payment for a house until about 4 years. But if we instead have $50,000 to invest while renting, the larger initial investment results in gains that remain greater than the savings from owning until about 6 years. When comparing the down payment options, a bigger down payment means a larger opportunity cost to recoup.
Kelsey and I made some smart financial moves (as well as some lucky ones) that allowed us to put down a 20% down payment. I decided to see whether we did in fact make the right financial decision to put down such a large down payment.
We paid $253,000 for our house but I like round numbers so we’ll continue to use $250,000. I imagined what would happen if we instead put down a $10,000 down payment and invested the other $40,000. If we did that, our mortgage rate likely would have gone up a little (I estimated a 0.05% rate increase for each $10,000 down payment decrease). But, we would have an initial lump sum to add to our investment portfolio, which we assume will average 9% annually. In this scenario, our investment from the $40,000 would have grown to over $530,000 over 30 years! If we subtract our expected costs of homeownership, our net worth would be $460,000. I did the same calculation, but with making a $50,000 down payment. Since there was nothing leftover from the down payment, there was no investment to offset the costs and our net worth from my calculations ends up being -$33,000… Yes there’s a negative sign in front of that number!
Needless to say, I was pretty unhappy. How could I make such a bad decision? Did I miss something in my analysis?
After taking another look, there was something I was missing. I wasn’t comparing apples to apples. In the $10,000 down payment scenario, I would have started with a larger initial investment but my monthly costs would have been $400 higher! When looking at the $50,000 down payment option, I didn’t account for the extra $400 a month I’d have from the lower down payment. If I assumed that the money saved from the lower monthly payments would be invested, the numbers start to look much better. With the lower monthly payment and putting the difference into an investment account, the $50,000 down payment option goes from a net worth of -$33,000 to just around $625,000.
So it turns out that a larger down payment does make sense (and we didn’t make a $490,000 mistake). When you’re deciding on a down payment amount, look to make the largest contribution possible. The savings you get from the lower monthly payment easily make up for the lost opportunity cost of investing the initial down payment.
(But if you already have your mortgage, think twice before paying that off early.)
