Should You Make a Large Down Payment on a House?
For some people this is a no-brainer… If you’re scraping together every last quarter you can find under the sofa cushions, then your bank account has already told you how much you can put down.
But if you’re in the position to make a large down payment, then you might be wondering whether or not you should. While making a smaller down-payment may help reduce your risk and increase your return on investment, there are advantages to a larger down-payment as well.
What is a Down Payment
First things first. The down-payment is the amount of cash that you bring into a purchase that is not being borrowed. In real estate, we usually talk about the down-payment as a percentage of the purchase price.
Here’s a quick example we’ll use throughout this article:
You buy a house for $400,000. You get an FHA loan so you can make the minimum down-payment of 3.5%, or $14,000. So you are borrowing the other $386,000. This gives you a loan-to-value (LTV) ratio of 96.5%.
The smallest down-payment you can make these days is about 3-3.5%. If you have $80,000 in the bank then you could also put 5%, 10% , or all the way up to 20% down for that same $400,000 house.
There’s no limit to how much you can put down, but you don’t want to just pick some random amount either. Different loan programs have different requirements about the down-payment, and choosing one over another will affect your monthly payment and thus, your eligibility for that loan.
The Advantages of a Large Down Payment
(How Your Down Payment Affects Your Monthly Payment)
All of the advantages of making a large down-payment have to do with reducing your monthly mortgage payment. Here are the three reasons that a larger down-payment would reduce your mortgage payment.
1. You are borrowing less money – No rocket science here. The bulk of your mortgage payment is made up of principle (the amount of the loan) and interest, which you pay back over the term of the loan. Let’s say the term for this loan is 30 years (360 months).
Let’s refer back to our example: what if we put down 20% ($80,000) to buy a house instead of 3.5% ($14,000)? In this case we would only be borrowing $320,000 rather than $386,000. But, since we are still taking 360 months to pay it back, our monthly payment is going to be smaller simply because we are paying back less money.
2. You are paying less interest – Because your down-payment is larger, the bank is going to offer you better loan pricing, so your interest rate will probably be better. Again, the bulk of your payment is principle and interest, so a lower interest rate means you will be paying less money in interest, which will give you a lower overall payment.
3. You can pay less, or even no, PMI (Private Mortgage Insurance) – Lender’s usually require you to pay private mortgage insurance on loans that have higher than an 80% LTV. This means that if your down-payment is less than 20%, you will also be paying a PMI premium as part of your monthly mortgage payment.
Typically, the premium is lower for lower LTV loans. For example, on an FHA loan with a 3.5% down-payment (96.5 LTV) your annual PMI premium would be .85% of the loan amount. However, if you increase your down-payment to 5%, your PMI premium would drop to .80%.
The Disadvantages of a Large Down Payment
… A Penny Saved is a Penny Earned.
When deciding on how big of a down-payment to make it helps to think of it as an investment. When you borrow money, you are going to be paying a certain rate of interest on that money… Let’s use a rate of 4% for this example.
This means that every dollar you apply toward your down-payment is a dollar that you are NOT going to be borrowing and paying 4% interest on. Alternatively, every dollar that you don’t apply toward your down-payment is essentially another dollar that you WILL BE borrowing and paying 4% interest on.
So when you put money toward your house as a down-payment you are saving yourself the 4% interest you would have had to pay if you borrowed it. In other words, you are effectively EARNING a guaranteed 4% return on the money you use for a down-payment.
Is it worth it?
4% is considered to be a pretty respectable return in the investment world, especially a guaranteed 4%. However, if you are a savvy investor and know that you can earn better than 4% investing that money elsewhere, then you may be better off making a smaller down-payment. This concept is referred to in the business world as Opportunity Cost.