One question frequently on the minds of first-time home buyers is: How much should I put down toward my home? The go-to answer is 20% of the value of the home, but that might not always be the best choice.
The reason why most people recommend putting 20% down payment on a home is that banks and mortgage lenders don’t require home buyers to purchase Private Mortgage Insurance (commonly known as PMI) when the amount is equal to or greater than 20% of the purchase price.
If the down payment is below 20%, the bank requires you to pay PMI to protect themselves against the possibility of default, which ends up being included in your monthly mortgage payment.
(Keep in mind, however, that PMI will go away once you’ve paid off a certain amount of the loan: when the Loan-to-Value reaches 78%).
As you can imagine, not having to pay PMI can reduce your monthly mortgage payment by quite a bit.
Let’s walk through an example to compare the numbers:
Steve and his wife are looking to put in a bid on a home valued at $300,000. They each have a good credit score and have enough money saved to comfortably put down 20%.
They know that PMI will be applied for a down payment of less than 20%, but want to see exactly how much they’d be paying per month at different down payment amounts.
If Steve and his wife put 20% down ($60,000), their monthly mortgage payment in this example would be approximately $1,590.
If they put 19% down ($57,000), they’d have to purchase PMI and their monthly payment goes up to $1,694.
If they put 5% down ($15,000), which is usually the bare minimum you can put down with most conventional loan programs today, their monthly payment on that $300,000 home would be approximately $2,000.
When does it make sense to put down less than 20%?
As you can see, the difference between 20% down and 5% down for Steve and his wife is $410 in their monthly mortgage payment – a 20% difference! That’s pretty substantial.
On the flipside, Steve and his wife would be keeping $45,000 liquid if they decided to put down 5% rather than 20%. That’s also pretty substantial.
Going back to the example above, the yearly PMI at the 5% down payment level is $2,172.
The question now is: is it worth it for Steve and his wife to put down an additional $45,000 today for the opportunity of saving $2,172 per year for some years (in fact, about 8 years in this case based on this loan’s amortization schedule)?
Of course, only Steve and his wife know the answer to that question. Maybe they’re better off investing the $45k in the stock market, or making home improvements to their new home, or starting a business. Or maybe they just feel nice and cozy knowing that they have an extra $45k in the bank, you know, for a rainy day.
Everyone’s opportunity cost is different, but the point here is that money has an opportunity cost and this is something Steve and his wife should consider when deciding how much they should put down on their home.
That might not always be 20%.
Final words of wisdom on down payments
All in all, the steps for a home buyer to determine how much to give as down payment are the following:
Determine the maximum you can afford to pay in monthly mortgage payments. This is usually a fairly easy exercise since you know your monthly income and how much you can afford to pay in rent. The monthly mortgage payment will probably not stray too far away from what you’re currently paying in rent, but be sure to account for not-so-obvious home expense such as repairs and insurance.
Determine how long you think you’re going to be staying at the property you’re looking to buy.
Determine how much money you have available as of this moment for a down payment. It is also worth calculating how much you can save every month to increase that amount.
Using a good mortgage calculator, determine the value of the home you can afford based on the target monthly mortgage payment you determined in Step 1.
Play around with the down payment amount and home price to arrive at a comfortable number.
As you can see, every single situation is different and the down payment strategy depends on many variables that are particular to you.
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