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.
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!
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?
*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.