The pros and cons of a 20% down payment

It’s been a rule for years: you need 20% of the home sale price for a down payment. But, there are so many exceptions to this rule today. Home buyers are feeling the pinch from higher education and healthcare costs, and many prospective home buyers just don’t have 20% of the home price available for a down payment. And even if you do have the money available, let’s discuss the pros and cons.

Pros

1) Lower mortgage rates

Mortgages are priced on risk – the riskier you are to a bank to lend to, the higher rate you will be charged. That’s why if you have a not-so-hot credit score, in order for a bank to lend to you, they will charge you more to buffer against the risk of you not making your payments.

Same thing goes for lower down payments – less money down from you means more risk for the bank. Here’s why: let’s say that a bank lends you 100% of the value of a home. If the market goes down and the home is worth less and you stop paying your mortgage, they are left holding the bag for more than what the home is worth.

If you put 20% down, it buffers the bank against home values dropping and you get a better deal.

2) Fewer fees

Often, if you put less than 20% down, in order to buffer against risk, a bank will require you to pay what’s called private mortgage insurance, or PMI. This is calculated on your remaining loan balance. You can stop paying it when remaining loan balance is 78% of the home value. It can take several years of paying down principal to reach this level. Also, with FHA loans you can put down as little as 3.5% but you have to pay a fee that gets rolled into your loan amount as well as a monthly charge known as MIP.

If you put 20% down, you won’t have to pay private mortgage insurance or fees related to low down payments.

3) Easier to refinance

Most lenders will want to see that you have 20% equity in your home in order to offer you a refinanced mortgage. If you don’t have 20% equity in your home, this can limit what you can qualify for and you may not be able to take advantage of better deals that become available to you. If rates drop and you can save $200 a month on your mortgage by refinancing, for example, you may find your options limited if you don’t have enough equity in your home.

4) Easier to move, if you have to

What if you owe your bank $95,000 on a home that you bought for $100,000 and all of a sudden you are offered the job of a lifetime… but it’s in a different city. You want to sell, but the market in your area has declined since you purchased your property and your only offer is for $90,000. That’s not enough to pay the bank back, let alone pay for the closing costs of selling your home. You will be stuck.

But, if you only owe your bank $80,000, you can decide to sell your home and move, just like that. Sure, you will lose money, but you won’t be stuck in a house you no longer want.

Cons

1) Money isn’t tied up in your home

If you have the money for a 20% down payment but you don’t want to put it in your home, you can choose to do something else with it, like invest it. Money that is invested in an index fund, for example, is easy to get ahold of, should you need it, unlike the money in your home. If you need money for some reason and the only money you have is in your home, you’d have to sell your home, or do a cash-out refinance in order to get money out.

Of course, this can also be a reason to put down a larger down payment, and is often referred to as “forced savings”, as it’s hard to spend it if you can’t get it out!

2) If you don’t have another option but homeownership makes sense

If you’ve done your homework and are aware of the pitfalls of putting less than 20% down and go into it with your eyes wide open, choosing to put less than 20% down can be an excellent option in order to become a homeowner. It can make sense particularly if you don’t think you’ll need to move soon, you won’t need to refinance soon, and the deals you are offered still make sense for the long term, as well as the present.