Down Payments: How Much Should you Put Towards them?
A down payment on a home mortgage is serious business.
The term “mortgage” originated in France with the meaning of “death pledge”, after all. Quite literally, for many people, once they take one on, they’ll carry it to their death.
I’ve read dozens of retirement stories lately where the retiree is still paying off a mortgage. As a side note, if you still have a mortgage, you should not be retiring. Numbers-wise, I suppose you could, but you are rolling the dice if you think a cushy pension will continue un-interrupted to allow you to do so..
But let’s not jump too far ahead of ourselves. For beginners who have not bought a house, what is a down payment, you ask? A down payment is the amount of money you apply directly towards a loan – in the case of a home, a mortgage.
The average down payment on new loans for home purchases is now more than 20%.
But is average good enough?
20% Down Payment Avoids PMI
Let’s start with this.
One of the biggest financial mistakes I’ve made was buying a big house almost right after graduation and over-financing it.
You can avoid PMI (private mortgage insurance) – which is where your lender literally charges you to pay for the insurance that covers their ass if you default on your loan – by putting 20% down on a house.
My wife and I, unfortunately, hit ourselves with a double whammy. First, we didn’t have any savings to put towards the down payment. Second, we bought too much house.
No savings meant we had to either take PMI or a second (piggyback) loan. Crunching the numbers led us to take out a HELOC at a 9% APR (prime rate plus a few percentage points) instead of PMI. We were paying over $1,000 a year in interest on this second loan, and it all could have been avoided if we had first saved up 20% for a down payment.
I’m not sure if piggyback loans or PMI are as common place today as they were pre-financial collapse, but they are both traps. Which brings me to my first piece of advice:
DON’T PUT LESS THAN 20% TOWARDS A DOWN PAYMENT ON A MORTGAGE.
Nobody NEEDS a home, and if you can’t save up at least 20%, you are not ready for one. Stick with renting.
This, believe it or not, is my “soft” view on down payments.
At Least 50%, Why Not 100%?
Mortgages right now are still around historical lows of 3.5% (15-year) and 4% (30-year). Great time to buy, right?!
Here’s the thing. The percentage rate you pay on a mortgage is an annual percentage rate. This means that you pay that interest rate every month (annual percentage rate/12) on whatever the remaining balance is. If you’ve never seen an amortization table, take a look. It will make you puke.
On a $200,000, 30-year loan at 4% interest, you would pay over $7,000 in interest for each of the first 6 years. Three-quarters of your payment would go towards interest payments while only one-quarter would go towards your loan principle. Over the course of the lifetime of the loan, you would pay over $143,000, almost three-quarters the original value of the original home.
4% guaranteed returns should beat inflation, convincingly. While you might be able to do better investing, that is nothing to scoff at.
If I could go back and do it all over? I’d probably put at least 50%, maybe even 100% down towards a home purchase. In some parts of the country, this would be almost impossible. In Michigan? It’s not.
Realtors and bankers are going to hate me for saying that (ever seen the National Realtor Association “never been a better time to buy” commercial?), but the bottom line is that the more you save towards a down payment, the sooner you’ll be 100% debt free. And the more secure you are from foreclosure and financial hardship. There are always exceptions out there, and local real estate markets might make buying/loan much more appealing than renting. But if you want a general rule, there it is.
Oh, but what About the Mortgage Tax Deduction?!
Whenever someone talks about deducting mortgage interest on a tax return as a blessing or a reason to buy a home, I cringe.
You can’t add a mortgage interest deduction on top of a standard tax deduction. For example, the 2016 standard deductions are:
- $6,300 for single filers
- $6,300 for married, filing separately
- $12,600 for married filing jointly
- $9,300 for head of household
- $1,050 for dependents
In my mortgage tax deduction breakdown article, I highlighted a common scenario where you could end up paying $13,000 (mortgage interest + property taxes) that you’ll never get back, only to get a whopping $60 in mortgage tax deductions.
So, there you have it.
Down Payment Discussion:
- How much do you think one should put towards a down payment?
- How much did you put towards yours?