There are three schools of thought on how best to pay for a home.
The first camp aims to borrow as much as possible, putting down as little cash as they can. A second group fixates on 20% as the magic down-payment number. The third aims to borrow as little as possible, or even to buy the home entirely in cash if they can afford it.
It turns out they all are — or at least, there are legitimate pros and cons for each strategy. The answer also depends on your personality and risk tolerance. As you plan out how to pay for your next home, weigh these pros and cons to find the perfect strategy for your needs.
A Brief Overview of Mortgage Types
Many borrowers’ eyes glaze over when they hear pundits expounding on Federal Housing Administration (FHA) loans, VA home loans, and conventional loans.
Parsing the various mortgage loan programs is a large topic, but you don’t need a Ph.D. in mortgage finance. You just need the basics.
If you’re a veteran who served in the armed forces, ask loan officers first and foremost about VA home loans. These loans allow as little as 0% down and often offer generous interest rates. They don’t require private mortgage insurance either (more on that shortly).
For those without military service, the next best option is typically a conventional loan. Conventional loans follow rigid loan programs dictated by government-sponsored mortgage giants Fannie Mae and Freddie Mac. But beware: These loans require reasonably strong credit.
Borrowers with less-than-stellar credit often opt for FHA loans, designed specifically to make homeownership possible for buyers with weak credit and little cash. They require a modest 3.5% down payment for buyers with credit scores as low as 580, and 10% down for buyers with credit scores ranging from 500 to 579.
The huge downside to FHA loans is that they require you to pay mortgage insurance for the entire life of the loan. Mortgage insurance protects your lender, not you — it’s insurance they take out against the risk of you defaulting on your loan. And you get the privilege of paying for it, usually costing you more than $1,000 per year.
Both conventional and FHA loans require borrowers to pay mortgage insurance. The difference is that conventional loans only require it if your loan covers more than 80% of the property value, while FHA loans require mortgage insurance until the loan is paid back in full.
Pro tip: If you’re going to be applying for a mortgage, start your search with Credible*. Within minutes, you’ll be able to compare multiple lenders all in one place.
The Argument for Putting Down as Little as Possible
The first home you buy is usually the hardest because you don’t have any proceeds from selling an existing home to use as a down payment. You have to come up with it on your own.
Compounding the problem, many young adults today face daunting student loan debt. They must choose between saving for a down payment and paying off student loan debt faster.
In those circumstances, the difference between a 3% and 20% down payment can mean many years of postponing homeownership. Therein lies the first major argument for putting down as little as possible: It minimizes the delay as you save up a down payment. You can buy this year, rather than four years from now.
Although homeownership isn’t for everyone, it has its perks. Beyond the privilege of painting your bedroom bubblegum pink if you like, the median net worth for homeowners ($231,400) is an eye-popping 44.5 times higher than the median renter’s net worth ($5,200), according to the Federal Reserve’s Survey of Consumer Finances.
Another reason to borrow as little as possible is the low cost of home mortgages. The Federal Reserve puts the average mortgage interest rate at 3.26% at the time of this writing. Compare that to the average credit card interest rate of 15.99% per CreditCards.com.
This ties into the final advantage of putting down as little as possible: It leaves your cash available for other uses. Beyond the need for cash in your emergency fund or for home repairs, you can expect to earn a higher return on invested money than the 3.26% charged by lenders.
Downsides to Borrowing as Much as Possible
Borrowing the maximum allowed mortgage for a home comes with several cons.
First, you have to pay private mortgage insurance (PMI) unless you qualify for a VA home loan. Although conventional mortgage borrowers can apply to have PMI removed once they pay the balance down below 80% of the property’s value, that still means years of shelling out money every month for PMI. It’s lost money, plain and simple.
Another drawback to borrowing as much as possible is that it drives up the origination fee or “points” in your closing costs. Points are a percentage of the total loan balance, so the more you borrow, the more you pay. Making matters worse, lenders may charge more points for loans that represent a higher percentage of the home’s value (loan-to-value ratio or LTV).
That’s because they price their loans based on risk. The higher the perceived risk, the more they charge. This applies not just to points, but also to interest rates. Higher-LTV loans typically mean higher interest rates.
Borrowing more money — and at higher interest rates to boot — means much more total interest paid over the life of the loan.
And the higher the percentage of the price that you finance, the more likely you are to fall underwater on your mortgage. If you borrow 97% of the purchase price and the housing market drops 5%, you’re underwater. You’re less at risk of housing market fluctuations if you borrow 80% LTV or lower.
Example Loan Numbers
Betty Borrower wants to buy her first home for $250,000.
With her good credit score of 725, she qualifies for a 97% LTV loan, so she only has to put down 3% or $7,500. However, the lender charges her 4% interest and 2 points, given the high LTV.
That means she borrows $242,500 at 4% interest, which puts her monthly payment at $1,158 for a 30-year loan. On top of that, she pays another $172 in mortgage insurance each month, for a total of $1,330 per month not including property taxes and insurance.
At the settlement table, she pays $4,850 in points alone, plus $1,000 in “junk fees” (flat lender fees), plus another $3,000 in other closing costs.
Over the entire life of the loan, she pays $174,283 in interest. Add in the $5,850 in lender fees at the table, plus let’s say five years of PMI coming to $10,306, and she pays $190,439 in total loan costs on top of her $250,000 purchase price.
The Argument for Putting Down 20%
For conventional borrowers, a 20% down payment comes with an enormous benefit: no PMI requirement. That potentially saves thousands of dollars each year in fees.
Bear in mind that FHA borrowers can’t avoid mortgage insurance, regardless of the down payment. It pays to have better credit and take out a conventional mortgage.
Beyond the ability to avoid PMI, conventional borrowers get several other benefits by putting down at least 20%. First, you typically pay a lower interest rate because lenders consider the loan to be lower risk. The same logic applies with points. Lenders charge less for loans under 80% LTV. You also experience a smoother, faster underwriting process for loans with a lower LTV.
The lower loan amount and lower interest rate reduce both the monthly payment and the total interest paid over the life of the loan. And lower monthly payments make it easier to withstand an emergency, such as a job loss.
Finally, you face a much lower risk of becoming underwater on your mortgage when you put down at least 20%.
Downsides to Putting Down 20%
As the compromise option, borrowing 80% of the purchase price leaves you with some of the worst of both worlds, not just the best.
You still make hefty monthly payments and pay a great deal in life-of-loan interest. You still have to shell out money for all those lender fees at closing, including both points and flat fees.
You also have to cough up plenty of cash, usually tens of thousands of dollars. That comes with two enormous drawbacks: delays in homeownership, and opportunity cost.
How long might it take you to come up with $40,000 as a down payment? How many years will you continue to rent, rather than buy?
The opportunity cost is just as real, if not as tangible. If you tie up $40,000 in your home, that $40,000 isn’t out in the world working for you to compound and build wealth. For those who argue that “your home is an investment,” the numbers disagree. Home prices only rise about 1% faster than inflation historically, according to CNBC. By contrast, stocks return around 10% per year on average — around 7% more than average inflation.
The greatest benefit of a 20% down payment — avoiding PMI — only applies to borrowers with decent credit who qualify for a conventional loan. For FHA borrowers, the benefits to a higher down payment remain limited.
Example Loan Numbers
Bennie the Borrower buys the house next door to Betty, which also costs $250,000. He puts down 20% on a conventional mortgage, putting his down payment at $50,000 and his loan at $200,000.
Because he borrows a lower LTV, the lender charges him 3.5% interest and half a point on his loan. That puts his monthly payment at $898 for principal and interest (compared to Betty’s $1,330 for principal, interest, and PMI).
The half a point comes to $1,000 as an origination fee, plus another $1,000 in flat junk fees. Over the 30 years of the mortgage, Bennie pays a total of $123,312 in interest. That’s over $50,000 less than Betty’s $174,283.
Adding the $2,000 in other lender costs, Benny pays a total of $125,312 in interest and fees over the life of his loan — roughly $65,000 lower than Betty’s total loan costs of $190,439.
The Argument for Putting Down as Much as Possible
On the other end of the spectrum lies putting down the maximum down payment, ideally paying entirely in cash.
Buyers who pay in cash pay $0 in points and $0 in flat lender junk fees. You can even skip the home appraisal if they feel confident that you aren’t overpaying for the home. You shouldn’t skip the home inspection, though, which primarily exists to protect the buyer (as opposed to the appraisal, which is done primarily to confirm value for the lender).
And, of course, homebuyers who pay in cash avoid monthly mortgage payments entirely.
Perhaps best of all, cash buyers have better negotiating power with sellers. Home sellers often accept significantly lower offers from cash buyers who can settle quickly over buyers who offer more but rely on lenders to fund the purchase. Those offers routinely fall through due to financing problems.
Even buyers who take out a relatively small mortgage see some benefits over those who borrow 80% or more. You pay the absolute lowest interest rates available for borrowers with your credit and other qualifications. Often, you can avoid points entirely and only pay the flat lender fees. Plus, the underwriting process for low-LTV loans tends to be relatively smooth and quick.
Downsides to Putting Down as Much as Possible
If it takes a long time to save up $50,000, how much longer does it take to save $250,000 to buy a home in cash?
The delay is why buyers who need to save up a down payment rarely put down more than 20% if they can help it. Only buyers who already have plenty of funds set aside consider buying homes in cash or with a huge down payment.
Still, cash buyers incur an opportunity cost. By buying a $250,000 home in cash, you might save 3.5% in interest. But you’ll miss out on 10% returns from having that money invested in the S&P 500. That’s hardly an attractive tradeoff.
The cash you pay to buy a house becomes home equity, which is notoriously illiquid. Sure, homeowners have a handful of options to pull equity from their home, but none are fast, and all come with significant upfront closing costs. The most common of those options include a home equity loan and a home equity line of credit (HELOC), each of which comes with its own pros and cons.
Ultimately, putting down lots of cash to buy a home can help you save money on interest and closing costs, and help you negotiate a lower purchase price. But you should only do it if you’re confident you won’t need to access that money any time soon.
Cathy the Cash Buyer pays $250,000 for the next house down from Betty and Bennie. She pays no lender closing costs, no interest, and no PMI and has no monthly mortgage payment.
Over the next 30 years, she saves $125,312 in avoided lender costs compared to Bennie and $190,439 compared to Betty.
Imagine, though, that Cathy and Bennie each have $250,000 in cash when they go to buy their homes. Bennie puts $50,000 toward his down payment, borrows the remaining $200,000, and uses his own remaining $200,000 to invest in the stock market. At the end of 30 years, even if Bennie doesn’t invest another cent, he’d come out with $3,489,880 if he earns 10% annually on his original $200,000 investment. Subtracting his borrowing costs of $125,312 and $200,000 in principal repayment, he ends those 30 years with $3,164,568 in his pocket.
Cathy puts all $250,000 into her house, and she instead invests the $898 she’s saving on a monthly mortgage payment into the stock market each month for the next 30 years. After those same 30 years, she has $1,867,205 if she earns the same return as Bennie on her money.
Although it’s a simplified example, it illustrates the power of leverage and opportunity cost. If you can borrow someone else’s money at 3.5% and invest your own money to earn 10%, you come out ahead. The real world is, of course, messier. If Cathy loses her job, she’s in a more secure position than Bennie. And avoiding debt comes with a guaranteed return, while all traditional investments come with risk.
Steps to Buy a Home Faster
Are you looking to buy a home, and you don’t want to wait 10 years to do it?
You have a few options at your disposal beyond simply taking out a high-LTV loan. Try combining several of these ideas to reach homeownership faster while paying the minimum possible interest, points, and mortgage insurance.
1. Improve Your Credit
The better your credit, the better the loan programs for which you qualify. Period.
With strong credit, you can take out a conventional mortgage and avoid the expensive, permanent mortgage insurance required by FHA loans. Better credit also helps you negotiate a lower interest rate and lower points with lenders.
As you plan for homeownership, start by improving your credit. The fastest way to do so is checking your credit report and disputing any errors you find on it. The second fastest way to boost your credit score is by paying down debts, particularly credit card balances. Get all your credit card balances below 30% of your credit limits for maximum impact on your score, then use the debt snowball method to pay off your remaining balances. Finally, sign up for Experian Boost, a free program that can instantly raise your credit score by giving your credit for your phone and utility bills.
2. Get Aggressive With Savings
There’s no way around it: You’ll need cash for a down payment, whether it’s 3% or 20% of the home’s price.
For example, among the many benefits of a Roth IRA, you can withdraw contributions tax- and penalty-free. Even traditional IRAs let you borrow up to $10,000 penalty-free to buy a home. If you haven’t set up an IRAm you can do so through brokers like You Invest by JP Morgan or TD Ameritrade.
3. Consider House Hacking
House hacking is the glorious art of getting free housing.
Traditional house hacking involves buying a multifamily property, moving into one unit, and renting out the other unit (or units) so the neighbors effectively pay your mortgage for you. Other ideas to house hack include bringing in roommates, renting out storage space, renting an accessory dwelling unit, or bringing in a foreign exchange student and using the stipend to pay your mortgage.
Creative house hacking, even in your existing home, helps you save money faster for a down payment. If you opt to buy a multifamily home, house hacking also helps you qualify for a mortgage. You can use the rental income from the other unit (or units) to help you qualify for your loan.
4. Negotiate a Seller Concession
It’s hard enough to save up a down payment. But when you buy a home, you also need enough cash to cover the closing costs. You also often need several months’ mortgage payments held in reserve.
To reduce your total cash tally, ask the seller to pay for your closing costs. It’s called a seller concession, and conventional loan programs allow the seller to provide you with between 3% and 9% of the purchase price in cash assistance, depending on the size of your down payment.
5. Negotiate a Seller-Held Loan
One way to minimize your down payment is to simply borrow money from the seller.
Sellers sometimes agree to lend you a small second mortgage to help bridge the gap between what you have and what you need. Although this is more common among hard-to-sell properties and urgent sellers, you can sometimes negotiate a seller-held second mortgage even with more typical sellers.
You may even convince the seller to finance most of the purchase, replacing the bank as your mortgage lender. They probably won’t charge as much in lender fees or require PMI, and you won’t need to pay for an appraisal either.
6. Ask for a Gift From Friends or Family Members
Mortgage lenders allow you to use gifted money toward the down payment on your home. The catch: it must be a true gift and not a loan.
And, yes, lenders do scrutinize your bank accounts for any irregular deposits over the last few months. If they discover you received money from a friend or family member, they demand a signed letter from your benefactor attesting that the money doesn’t need to be paid back.
Still, you can always negotiate nonfinancial ways of paying back friends and family members for their generosity. Perhaps you can offer babysitting every Friday night for the next year, mow their lawn, or let them borrow your car whenever they need it. Get creative with it!
Homes are the largest assets most people ever own, and they’re expensive. Long before you start house hunting, you should start strategizing how to foot the bill for it.
If you can find a way to put 20% down on a home, it saves you considerable money and headaches in the long term. It also reduces your risks as a homeowner, both of falling upside-down on your mortgage and of finding yourself unable to make your mortgage payments.
If a large down payment proves infeasible for you, you can still lower your borrowing costs by boosting your credit score and by taking out a conventional mortgage rather than an FHA loan.
How much are you planning to put down on your next home? Why? How are you planning on coming up with the down payment?
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