You’ve probably heard that you need to have 20% of the purchase price of a home saved as a down payment before you you’re ready to buy a house. But why? While many of us know what we’re supposed to have saved, it’s surprising to find out that most potential buyers don’t know the reason behind it.
Having 20% down means two things:
- You don’t have to pay Private Mortgage Insurance (PMI).
- You might get slightly better loan terms.
But here’s the part most people don’t know – if you’re buying a home for your primary residence, waiting to save that 20% isn’t necessary and might actually hurt you financially. Let’s take a look at why.
Let’s address PMI first. PMI is additional insurance that your lender will charge you monthly for if you do not pay 20% of the value of the house when you close. It’s basically an insurance policy you pay for that benefits the lender in case you default and go into foreclosure. Now, you might be hung up on the idea of paying for an insurance policy that doesn’t directly benefit you, but let’s talk about how it actually can.
Lenders want to avoid risk, and foreclosures are expensive and usually end up costing them money. To help ensure that they’re covered, they have insurance policies that that help make up for the additional risk of loaning to someone who doesn’t have the 20% down. While PMI is an additional monthly expense, it should be considered more like an opportunity because it allows you to borrow earlier and more strategically.
In Austin as of April 2018, the median home price is $404,217 which is up 9.2%(!!) since April of 2017. (1) And it’s not an anomaly, either. The average house price increase went up 9.6% the year before. So basically, in just two years the average home price went up just under 20%- pretty much the same amount you need for a down payment. Trying to out-save the market increases can be almost impossible for the average buyer.
Your next question is probably this: How does PMI payments stack up to all of the growth? Well, there are plenty of PMI calculators online that will give you a general estimate of what your monthly premium will be. Let’s do some math and compare PMI to average growth during just one year.
Let’s say that a $400,000 house with 3% down (and decent credit) will give you a PMI payment of about $177 a month*. Over 12 months that totals to $2,124. If the housing market continues to rise at this year’s rate, 9.2%, then the property value would increase $36,800. The difference is a staggering $34,676. Even if the years’ growth slowed by 50%, the difference would be $17,876. The numbers make it pretty clear that in this market, waiting does not make much sense when considering PMI.
Another awesome secret is that you might not be stuck paying PMI until you reach 80% value of the loan. Many modern loans have a provision that allow for reappraisals which gives you and the bank the new value of the property. Once the property is worth more than a certain percentage of the loan, the bank will drop PMI. Make sure to talk about this provision when you’re shopping around for loans to get the specific details- every loan and lender will be a little bit different
The second common worry is that if you don’t have 20% down you won’t get a good interest rate and favorable loan terms. The first thing to consider is that many people currently don’t have the 20% to put down and many lenders have come to realize the new normal. Putting down 3-5%, especially in high growth markets is fairly commonplace so don’t feel bad/weird/irresponsible if you don’t have 20% – you’re in good company!
Many lenders are now prioritizing on other qualifying things such as credit score, debt-to-income ratio, average income, etc. So get your financial house in order (and check out our tips on how to do so here) before you apply for a loan but please, while the market’s hot don’t wait until you’ve saved that 20%!