What if I Lower My Down Payment?
There is more than a single path to homeownership and it’s worth knowing your options.
Everyone’s personal finances are unique, so no matter what “general” advice you get, you’ll need to figure out how does it apply to you. Sometimes you just don’t get a chance to execute on a prescribed strategy.
We have talked about how the maximum you can afford is mainly based on your monthly salary, and discussed the general outline of a high-savings diet to help you save for down payment. This time, we are going to talk about a more complex situation involving a down payment lower than 20%.
For example: Alex and Taylor have $100,000 annual income (before taxes), don’t pay too much in rent ($2,000 a month = 24% of income), but only have $16,000 in the bank and are only able to save $200 a month. The most expensive home they can buy is $480,836, in theory.
If they were to buy a $400,000 home, their monthly housing costs would be around $1,941 which is 83% of the maximum they can spend. It seems they are giving themselves enough breathing room, but there’s a problem: it will take them 26 years and 8 months to save for the 20% down payment at that rate. Ouch.
Many people end up contemplating results like this and thinking that homeownership is impossibly out of reach. The math is clear: they must spend way less and save way more. For instance, let’s suppose that Alex and Taylor increase their saving rate to $500 a month. It’s still going to take them over 10 years.
Then, they start considering what else is on the table and wonder what would happen if they put less than 20% as down payment. And the short answer is: their time to purchase will decrease, but so will their purchase power and ability to compete in pricing with other buyers.
When you put less than 20% down payment, lenders will demand you purchase Private Mortgage Insurance (PMI), which is essentially insurance for the money they might lose if you don’t pay your mortgage. The cost of PMI is proportional to the risk: if you have a better credit score, you pose less risk to the lender, so you end up paying less in PMI. Also, the closer you are to 20% down payment, the less risk too. After many mortgage payments, PMI usually goes away because you’ve paid enough of your loan such that the lender assesses the risk they will lose money in case of default is back to normal.
But, PMI is a monthly recurring cost related to housing, so it gets considered in the 28% limit we’ve discussed before. In other words: the amount you pay in PMI directly “eats up” from what you can afford.
Back to the example: now that Alex and Taylor are saving $500 a month, they decide to work with a 5% down payment and figure out they can make things work for a $345,000 property and below.
Indeed, with the increased savings and reduced 5% down payment, it will take them only 3 months to save the remainder of the $17,250. They will be paying a total of $2,331 a month (the maximum they can afford per the 28% rule), but hundreds of dollars will be spent exclusively on PMI. That money is not paying for the mortgage principal, so it is not coming back when they decide to sell in the future.
$345,000 represents 72% of the maximum they could afford otherwise with a 20% down payment. In this example, they’re trading 28% of their home purchase power in exchange for a reduction in the down payment from 20% to 5%. It will allow them to buy a home faster, but they will be limited in what home they get to buy.