Homeownership with a Low Down Payment

Does homeownership make sense if we buy a place with a low down payment? How much does PMI cost us? I explore both of these questions as we consider taking a low down payment offer of either 3.5% or 5% for our current condo.

Why a Low Down Payment Can Make Sense

I’ll dive into the numbers below but first I’ll address another reason a low down payment can make sense. I’ll also briefly touch on the rent vs. buy discussion below, but for the purposes of this article, I’m focusing on the buy side analysis.

Today, millennials have delayed homeownership due tomyriad of factors.

Underemployment, student loans, and flash backs from the Great Recession come to mind.

Low or even no down payments helped create a financial Armageddon in the Great Recession. Of course, there are dozens of other large factors, but one of the reasons people ended up underwater on their mortgages was because they purchased homes traditionally outside of their budget.

Using the DD household as an example, let’s say we are approved for a $1,000,000 home and we only need to put down $50,000. Our first thought MIGHT be, “Okay, the bank is smart and knows what we can and cannot afford. By allowing us to take out such a large mortgage, then surely this is what we can afford.”

Spotty analysis on large purchases can ruin us financially for the rest of our lives.

I don’t mean to sound melodramatic, but purchasing a home is often the single largest decision we make on our path to financial freedom. Making the right choice becomes even more critical given the weight of the decision.

Alternatively, if we are looking to purchase a home for $200,000, which is 1.5x our annual income from 2016, then a low down payment becomes inherently less risky.

Our chances of defaulting on a home loan becomes significantly lower if our budget is not stretched to the last nickel and dime.

Being responsible for a home purchase is one step on a broader path of financial success. So far in our story of pursuing financial independence, we’ve hit all the major milestones.

We don’t carry balances on high interest credit cards.

Our retirement accounts are now maxed out!

The pile of student loan debt is taking a beating now that we’ve refinanced AND accelerated principal payments.

We’ve tripled our savings rate from 20% to 60% and ended up with a more enjoyable lifestyle.

Naturally, our parents disagree because they ask us…

When Will We Become Homeowners?

Is rushing into the home ownership game a terrible idea? We don’t necessarily think so.

Of course, we can dive deep into the whole “rent vs. buy” arguments, but for now, I’ll provide our cliff note version for OUR particular circumstances.

We have plans to stay in Chicago for at least the next few years. Even if we move to another state, we can rent out the place. The location is literally the heart of Chicago so we expect many more young professionals to need to rent near their 80+ hour public accounting and banking jobs.

Most importantly, we understand mortgages are a liability at the end of the day, no matter how you look at it. Owning a home is not my ticket to millions, that’s why we own stocks. (I touch on investment properties below.)

So, now that you can see why we want to buy a home for a mix of reasons, let’s get to the heart of the discussion.

Buying a House With a Low Down Payment

When it comes to our options we will assess two: 20% down or 5% down. In other words, we will either take a mortgage out on 95% of the home’s value or 80%.

PMI, or Personal Mortgage Insurance, is typically 0.5% to 1% of the full loan amount each year. In our example, we’ll say the condo retails at $200,000 because we love to live big in a tiny home.

Well, 700-square-foot-tiny. So, not totally tiny.

Naturally, with a higher mortgage, that will also inflate the monthly mortgage payment.

As a corollary, with a smaller down payment, I can place that money into an index fund that tracks the entire economy.*

Historically this means ~7% return with a ~2% dividend and ~2% inflation, so we’ll round it all out to ~7% inflation adjusted total return.

The Numbers on a Low Down Payment

On a full thirty year timeline, the total cost with PMI is an additional $40,000, BUT we retain the ability to refinance once we reach a 20% threshold of equity owned.

Things begin to change after we account for the additional cost being negated once a 20% threshold is reached AND when we account for additional time needed to go from a 5% to 20% downpayment..

When running the numbers, it makes sense to buy a home with a low down payment.

Surely, that can’t be right. More money up front means less of a risk and a more secure transaction.

Yes, that’s true… for the bank. As the buyer, you are left with less cash on hand while still owning 100% of any new equity in your home.

In other words, if you have a mortgage for 80% or 95%, either way you still own 100% of the rise in equity. When your house goes up in value by $10,000, that 10k is yours, regardless of the amount on our mortgage.

This should be common knowledge but it isn’t.

I recall talking to a Big4 Public Accounting partner about this topic and even he told me I was wrong. I’m not sure how the conversation came up but it was a bit shocking and funny to see him try to explain it.

Needless to say, a few days later he saw the value in my approach and I gained a bit of respect from him – too bad it didn’t translate into working less hours at the time!

How Much Does PMI Cost Us?

As noted above, PMI costs us 0.5% to 1.0% each year.

For example, a $100,000 loan would equal an additional $1,000 in annual PMI payments.

While many harp against PMI, I’m here to tell you PMI is a small price to pay in exchange for owning a home sooner.

But, having access and making the right decision are two different things.

In our case, we want to aggressively pursue building wealth and access to greater degrees of leverage is inherently inviting.

For now, we are focused on hitting a 3.5 to 5% down payment, while avoiding the “incentives,” to save up to a 20% downpayment.

Alternative Strategy – Buy an Investment Property

Another strategy we’ve discussed is the option to buy a multi-unit building and live in one of the units. With the type of FHA loan we are looking at, the value of the rentals is factored into the mortgage calculations.

Another name for this practice is House Hacking.

For more on other ways to save with mortgages and even cooler concepts such as living rent free, check out this interview from the Podcast:

Hypothetically, we could buy up to a 4 unit building and begin to diversify our cash flows. This topic opens up the doors to discuss real estate investing, but given the length of this article, I’ll leave that conversation for another day!

Would you purchase a home with a low downpayment of 5% or even as low as 3.5%? If you’ve already purchased a home, what was your experience with handling the down payment? Would you have chosen a lower down payment in hindsight?

-Matt

*The scenarios above assume the 20% is cash on hand, ready to be deployed.

P.S. The clock is ticking! Be sure to sign up for early bird access to the course while the offer still stands.

12 comments… add one
  • Matt @ Optimize Your Life May 18, 2017, 7:05 am

    I hadn’t thought of it like that, but it makes a lot of sense. The biggest problem with small down payments was that people were using them to buy houses that were too expensive. The next problem would be that most people paying PMI would not have the knowledge or self-discipline to put the extra portion of a down payment into an index fund. If you have a better understanding of your money and can run the numbers, it may make sense to take on the PMI.

    I haven’t done too much detailed number crunching on home ownership because in our area it is far more expensive to own than to rent. Until we can get down to a monthly mortgage payment that is at least roughly comparable to rent, we’re holding off.

    • Distilled Dollar May 18, 2017, 9:48 am

      Yep! Sadly much of the leverage we have access to as individuals ends up burning large numbers of people.

  • AdventureRich May 18, 2017, 8:41 am

    Hi Matt-

    Spot on! Mr. Adventure Rich and I bought our “forever home” in the fall of 2016 (perfect location, 10 beautiful acres, etc). We had enough money for a full 20% down payment, but we opted for putting 15% down for the following reasons:

    – While we had the $$ for a full 20%, by the time closing costs and all other new costs came into the mix, we would have been tapping into our Emergency Fund to a level we were not comfortable with

    – With the Closing Costs, the seller was selling “by owner” and refused to pay the buyer Realtor fees. Our Realtor worked with us and gave us a very generous 50% discount, but this was still an unanticipated cost

    -The PMI totals $29.61/mo… $335.32/yr. We are paying a bit extra on our mortgage each month (Goal= Pay off by the time our almost 2 yr old son graduates high school). This cost was worth it to keep a better emergency fund in place. It will take us 20 months to get to the point of dropping PMI, so a total of $592.20.

    House Specs:
    – $220,000 Home
    – 3.5% Interest Rate
    – 30 Year Fixed

    • Distilled Dollar May 18, 2017, 9:46 am

      Wow – what a great deal! Thanks for sharing and it gives me some extra confidence with the low down payment approach.

  • Financial Coach Brad May 18, 2017, 9:00 am

    Looks like this is another area we disagree. 🙂 By this logic you wouldn’t ever pay off your mortgage. Why if the math works better investing? Pay down to a certain level and then take out an equity line to invest that money – right?

    It works for some people, but I prefer a better balance of risk/reward. We made the decision to pay cash for our house (yeah, 100% down) even though we could get a 3% rate (at the time) and put the money into investments.

    Having no mortgage lowers a lot of our risk – and our monthly living costs. Our actual invested money is aggressive – 100% stocks, no bonds at all.

    So certain things we go super-aggressive and some things more conservative. It’s like a balanced “life portfolio.” 🙂

    But, for people who thrive on riskier situations, go with the math for sure.

    • Distilled Dollar May 18, 2017, 9:14 am

      I’m not sure we disagree since buying a place 100% cash down is a different scenario than I was focusing on.

      Would you suggest someone take an extra 24 months to save for a property or should they opt for a lower downpayment if it means they can buy today?

      • Financial Coach Brad May 18, 2017, 9:26 am

        Personally I’d wait. But I know a lot of people who buy with as little down as they can.

        The house before this one I put exactly 20% down – and payed 1.5x the payment each month to accelerate the payoff.

        I get it though. Renting can suck. Renting is also very expensive here in my area.

      • Financial Coach Brad May 18, 2017, 9:31 am

        I’ll also clarify, there are a lot of “unless” or “except” type of situations.

        What I REALLY disagree with is someone stretching their credit and payment to the max to buy as much as they can qualify for. Then also not be able to cover a good down payment so they opt for 2-3% down. That’s very dangerous.

        People can also put 10%+ down and get into a similar situation though. At least then they have enough equity to get out of the house if a major emergency happens.

        This doesn’t at all seem to be your case though. I’m not judging and don’t see big red flags here. More of a personal preference on risk/reward.

        Thought I should clarify that. 🙂

        • Distilled Dollar May 18, 2017, 9:45 am

          Cool! Sounds like we are mostly in agreement!

          I’m in the same boat in terms of many people buying more than they realistically can afford. Growing up around real estate gave me too many real life examples of how buying the wrong home can lead to years of financial turmoil and recovery.

          Thanks again for the comments!

  • Lily @TheFrugalGene May 18, 2017, 10:42 pm

    Our first property we put down 25% and our second property we put down another 23%. With the stock holdings how it’s been, it has been huge mistakes. We probably lost 50-100K of growth but would I buy a house with a 5% payment down? Nope nope nopey! That’s silly right? It’s more of an emotional thing. I don’t want to walk and sleep in a house that I have 5% stake in, I want it to be 1/5 to 1/4 mine. Lol. Silly huh?

  • Cody @ Dollar Habits May 19, 2017, 1:23 pm

    We purchased our home at the bottom of the market, putting only 3.5% down (the most we could afford to put down at the time) with an FHA loan. Of course, this meant taking on PMI which totally sucked. However, I would do it again in a heartbeat. We paid just under $10k in total PMI costs over the 5 year period, however, we experienced a $180k gain in appreciation/equity/net worth over that same period. Had we waited to save up the 20% down, we would have missed out on an incredible buying window. Hope that example helps in some way. I look forward to seeing what you guys decide on.

  • Ryan @ Just Another Dollar May 22, 2017, 10:31 am

    We have been having many of the same discussions in our household over the last few months as our current rental lease comes to an end. We live in a very expensive and upward-trending market (Denver) and the entry level price point will likely be over $300k; higher if we end up pursuing a duplex or income property. We’ve decided to renew our lease through October 2018 and use the extra time to clear up the rest of our consumer debt and then split our savings between paying down our remaining student loans and building a down payment/emergency fund for our first house. While our income would probably qualify us to go out and buy something right now, being house-poor isn’t a risk we’re willing to take.

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