Is it Better to Put a Large Down Payment on a House?

by Arlene Isenburg

For decades, conventional wisdom told us to make a down payment of at least 20%. But times are changing with the average first-time buyer putting down 6%. So is a large down payment the right way to go? Like everything else, there are benefits and drawbacks. Let’s explore some of them so you can make the best decision for you and your family. 

Benefits of a Larger Down Payment

More Attractive Offer

An offer with a higher down payment will be more attractive to the seller and may help you outbid your competition. Price matters, of course, but it’s not everything. Sellers also have to take into consideration the likelihood of the deal closing. In other words, a buyer can make the highest bid and offer tens of thousands more than their competition, but if they can’t get a mortgage, the deal is off. Sellers know that buyers who make a larger down payment are more likely to get a mortgage, and therefore, the sale is more likely to go through. So the seller considers which buyer is more likely to actually be able to buy the home. That may mean the seller choosing a lower offer with a higher chance of the deal going through over a higher offer with a lower chance of the deal going through. In addition, a larger down payment may make your offer more attractive, because sellers feel comfortable that you won’t nickel and dime them or ask them to pay closing costs.

No PMI and Lower Closing Costs

If you put down less than 20% (meaning you borrow more than 80%) of the home’s purchase price, you will probably have to pay private mortgage insurance. PMI is a requirement from the lender for their own self-protection should you default on the loan. And you would need to keep paying for PMI until you accumulate 20% equity in the home. This could be thousands of dollars on top of your other costs.

A larger down payment also lowers your loan-to-value (LTV) ratio and all costs associated with it. When applying for a mortgage, your lender calculates your LTV ratio to determine how much risk they’re taking by giving you a loan. The lower the LTV ratio, the less risk the lender is taking on you. This means lower fees, lower closing costs, and even lower interest rates and monthly payments. To compensate for higher risk, lenders tend to charge higher fees. Where LTV ratio is concerned, the lower, the better to avoid extra costs. 

Smaller Loan to Pay Off

Simply put, the less you borrow, the less you have to pay back. And a smaller loan may even allow you to pay off your debt sooner or to get a short-term mortgage with a lower interest rate. A smaller loan can also provide some financial breathing room for other expenses and investments. 

Low Credit Score Compensation

If you have low credit, getting a mortgage may seem impossible. But a larger down payment can help you secure a mortgage even with low credit. When it comes to lenders, it’s always about risk. They want reliable borrowers who are more likely to pay them back. The more money you put down, the less of a risk you pose, and the more likely they are to approve you.

Low-Interest Rates and Less Total Interest

 You may be incentivized to make a larger down payment. Since lenders see you as less of a risk with a larger down payment, you may get a better interest rate. Lenders love borrowers with smaller mortgages (and therefore bigger down payments), because it means they’ll be likely to sell the house for more than the mortgage amount in case of a foreclosure. In other words, with a smaller mortgage, the lender makes more money on the sale of a foreclosed home.

Interest rate is one thing, but you also have to think about the total interest owed over the life of the mortgage. The interest rate and the size of the loan affect the total interest owed. So a smaller loan + lower interest rate = less total interest.

Smaller Monthly Payments

The above factors (a smaller loan, lower mortgage rates/fees, no PMI) combine to lower your monthly payments. That frees up cash monthly for whatever you may need to spend it on--home maintenance, investments, or even to put away. 

Flexibility

One benefit of a larger down payment is simply flexibility should you need to sell your home sooner than expected in the event of job loss or another unexpected life change. With less of a loan to pay off, the homeowner has more flexibility to make decisions. When deciding to sell, a homeowner must weigh many factors. A smaller mortgage is still a factor, just less so.

Debt-Free Sooner

With a larger down payment, you may be able to pay off your mortgage faster. With every mortgage payment you make, you are acquiring equity in your home with the ultimate goal of owning 100% of it. The faster you pay off the mortgage, the faster you own your house and get out from under your debt. With a large down payment, you instantly have more equity.

Drawbacks to a Larger Down Payment

Longer Wait to Become a Buyer

The bigger your down payment, the more money you need to save. Depending on your financial situation, that could take months or years, which might mean renting longer and delaying buying a home. If your options are putting less down to own a home sooner vs. renting for longer to save up for a large down payment, you may decide the former is the better choice. Plus, you can always refinance with better rates in the future. So if you want to buy a home and stop paying rent, it may make sense for you to pay a smaller down payment, gain some equity, and then refinance a few years later.

 Less Short-Term Financial Flexibility

Paying a large sum of money at once can hurt your wallet. Once you make a down payment, that money is gone. Whereas, holding onto that money longer and spreading it out over larger monthly payments can be helpful in the short-term by allowing you to keep more cash on hand. You may find that your new home needs some repairs or that you need extra money to pay other expenses. Or maybe you just want to invest it or put it away in the event of life’s unexpected expenses. A smaller down payment won’t drain your savings.

Wait for Long-Term Savings

A larger down payment may pay off more in the long run if you’re in your forever home. But it doesn’t do much good if you don’t plan on staying there long-term. If you’re in a starter home you only plan on living in for a few years, a large down payment may not make sense, as you may not live there long enough to see the benefits.

Down Payment Assistance Programs

There are many special programs that help lower-income and/or first-time buyers. Programs differ, but many offer grants for down payments/closing costs and low-interest or even no-interest loans. There are also grants and loans that don’t have to be paid back at all, or at least not if you live in the home for a certain amount of time. If you’re eligible for these programs, this is an area to consider instead of a large down payment. There are also VA loans, FHA loans, and USDA loans, among others. So investigate all loans available to you before deciding on a down payment.

Final Thoughts

There are trade-offs to everything. A larger down payment may lead to savings in the long run with a smaller loan amount, total interest, and monthly payments. But it could also drain your savings, leaving you without money for expenses or a cushion in case of emergency. A smaller down payment may lead to savings in the short term, giving you more cash to pay bills, to keep in case of emergency, or to invest. But it could also lead to higher interest rates and higher monthly bills, costing you more over the life of the loan.

So how much should you spend on a down payment? The answer is...there is no right answer. The answer is unique to you and your situation--your finances, your plans/goals, and your lifestyle. Consider the above factors and talk to your financial advisor to figure out which is the right path for you.

 

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