You’ve got a job, you are able to pay off debts, and you have the capacity to pay off a monthly mortgage. The down payment may be the only thing keeping you from owning a home. A down payment is money you pay up-front to lock in a purchase deal of a home, vehicle, and other assets. It usually comes out of your own savings, a spouse or partner’s savings, or monetary gifts from family members.
One common question around home-buying is whether it is better to put in a bigger or a lower down payment.
The Common Practice
First, let’s see what the common practice is.
According to a 2016 report from the National Association of Realtors (NAR), the average down payment made by American home buyers is 11%. It is even lower for buyers aged 35 and under who typically have lower income than those in their 40s and 50s. Typically, home buyers want 90% loan-to-value when taking out a mortgage loan and make as low down payment as possible.
Home buyers don’t want to spend their every last dime on a home as they know that the real spending comes after the home purchase. According to the NAR, buyers of a brand new home spend more than $10,000 on furnishings, appliances, and repairs in the first year after purchase. Buyers of existing homes spend more than $8,000 in that first year.
An independent study by NerdWallet, on the other hand, showed that a third of Americans think that you need to make a 20% down payment or more to buy a home. Viewed by generation, 21% of millennials think that this is required, as do 27% of Gen Xers and 36% of Baby Boomers. More than 40% of those who do not currently own a home say that the down payment is what holds them back.
Despite the lower down payment options available, there is still confusion and misinformation regarding the required amount of down payment when purchasing a home.
Advantages of Both Options
The decision to either go big or go small on the down payment relies on many factors, and you must take the time to evaluate both options and see which fits you best. These factors may include your personal financial situation, marital status, age, income, credit history, and how much you’ve been able to save for the home purchase. Both options offer their own advantages. Let’s weigh in.
Bigger Down Payment
- You end up paying less for your home. Paying 20% versus 5% down payment can spell huge savings down the road. Say you are buying a home worth $200,000. With a 20% down payment, you only have $160,000 left on mortgage loan plus interest; while making a 5% down payment leaves you with $190,000 on loan, which will garner a higher amount in interest. Plus, you can qualify for a lower interest if you pay a bigger down payment.
- No more mortgage insurance. By paying a higher amount for the down payment, you can skip paying private mortgage insurance (PMI), which lenders require buyers who pay a low down payment as assurance that the latter will pay the larger loan amount over time and in full.
- You’ll be more competitive. In a crowded market, a buyer who pays a bigger down payment is preferred by home sellers, as this is an indication that the buyer has solid finances and the mortgage loan is most likely to be approved.
- Lower monthly obligations. Higher down payment means lower monthly payments. In the event that you change or lose your job, your lower monthly mortgage won’t make as much financial dent as a bigger one.
- Increased borrowing power. Having lower monthly obligations can increase your likelihood to be approved of future loans. Lenders want to see that you still have more than enough income to pay monthly installments.
Smaller Down Payment
- You’ll have emergency reserves. Paying a low down payment leaves you with more cash to use for other expenses that go with owning a home. As mentioned earlier, owning a brand new house typically costs another $10,000 in the first year on furnishings, appliances, and other expenses. You should also have funds left for emergency expenses such as repairs.
- You can buy your home earlier. It may take you a while to save for 20% of the price of your dream home. By buying your home earlier, you avoid higher interest rates in the future and take more advantage of the appreciating value of the property.
- You get out of the ‘rent trap’ sooner. It is even harder to save for down payment with the rising rental rates. By paying a lower down payment and owning a home sooner, you avoid the rising rents sooner, as well.
- Opportunity cost. Even if you’ve saved for 20% of the price of the house you’re eyeing, you may opt to put down a lower amount and use the rest of the money for other purposes such as growing a business, saving for retirement, or remodelling a part of the home, which in turn, can increase the value of the property.
These are just some of the advantages of either option. Whether to go big or small on the down payment will really depend on your situation. Take due diligence in evaluating all factors and see which benefits you best. The down payment plays a big role in your mortgage and home-buying journey, so an informed decision is critical.