Why 20% House Down Payment?

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monkey_business
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Why 20% House Down Payment?

Postby monkey_business » Thu May 18, 2017 1:20 pm

The standard advice for a down payment on a mortgage is 20%+. In the context of financially responsible individuals, such as Bogleheads, why is this the recommendation? Allow me to explain the various points that are making me question this advice:

- The money you have as principal in your house is at a risk of 100% loss until the mortgage is fully paid off. Even if you pay off the mortgage down to one last payment, if you fail to make that last payment, your equity goes to the bank in the event of foreclosure.

- Putting more money into the mortgage reduces the amount of interest that you pay. However, given the current low rate environment, and (in many cases) the mortgage interest deduction, isn't the money more likely to generate a higher return in a low cost index fund?

- The house appreciation/depreciation is not connected to your equity. In other words, the house will be worth what it will be worth, when you sell it, regardless of how much equity you have.

- Aside from saving interest, the equity, past the mortgage note length, is returning 0%, effectively losing purchasing power.

- 20% down avoids PMI. However, many companies (at least based on my research), offer PMI-free mortgages with as little as 5% down. In exchange, the APR on the mortgage is higher. The difference is usually 0.15%, at least here locally. The PMI ends up being far more than a 0.15% difference. Investing the additional 15% of the down payment into index funds seems to be a better idea long term than saving 0.15%/year on the mortgage.

That said, as I mentioned in the beginning of the post, this assumes the individual(s) getting the mortgage live below their means, and are Boglehead-ish. For the average person, 20% down is probably optimal.

What am I missing here?

alex_686
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Re: Why 20% House Down Payment?

Postby alex_686 » Thu May 18, 2017 1:27 pm

The first leg is expense, in interest and PMI. Generally the best options are with 20% down which is why we generally advise it. If you can find exceptions good for you.

The second is risk. If you put 5% down and the market drops 20% you are underwater. This limits your options. Need to relocate for a better job? Upgrade to a large home because your family has grown? Those options are now off the table.

I will discount your advice for a low down payment and put the money in the market. Compare apples to apples. You are comparing a low risk low return negative bond to a high risk high return stock market. I am o.k. with leverage but it is not a free lunch.

Veni Vidi Decessi
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Re: Why 20% House Down Payment?

Postby Veni Vidi Decessi » Thu May 18, 2017 1:42 pm

The banks will take the balance they are owed from a foreclosure. The only way you lose all of your money is if the house is sold/auctioned/etc at a value lower than your remaining balance. If you only have one payment left, the likelihood of this is near-zero and is a misrepresentation of reality.

Second, I am unaware of PMI-free options for the average consumer (VA loans or others excepted). There is lender-paid and borrower-paid PMI. I have not seen an attractive lender-paid option (paying all PMI upfront, which increases the APR - this is probably what you are talking about).

Third, you are comparing paying off a negative bond with a guaranteed ~4% rate of return with a non-guaranteed stock investment. Investing instead of paying off your home (or instead of a larger downpayment) must be viewed as leverage. For most of us, this kind of leverage is unavoidable as we cannot afford to pay cash for a house purchase (unless we prefer to live in refrigerator boxes???). Even though this kind of leverage is typical and expected in life, it does not change the fundamental financials of entering into such debt, nor does it mean that a direct comparison of the two types of investments is now valid.

Jags4186
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Re: Why 20% House Down Payment?

Postby Jags4186 » Thu May 18, 2017 2:35 pm

monkey_business wrote:- The money you have as principal in your house is at a risk of 100% loss until the mortgage is fully paid off. Even if you pay off the mortgage down to one last payment, if you fail to make that last payment, your equity goes to the bank in the event of foreclosure.


If they foreclose on you they will sell the house, take what you owe, and you get the rest. Obviously it's in your interest to not do this as if you owe very little and foreclose the bank has no reason to try and sell the home for top dollar.

monkey_business wrote:- Putting more money into the mortgage reduces the amount of interest that you pay. However, given the current low rate environment, and (in many cases) the mortgage interest deduction, isn't the money more likely to generate a higher return in a low cost index fund?


Maybe, maybe not. If you take a 30 year loan at 3.75% and interest rates go up to 7% or 8% over the next 10 years, then things are good.

monkey_business wrote:- The house appreciation/depreciation is not connected to your equity. In other words, the house will be worth what it will be worth, when you sell it, regardless of how much equity you have.


Not sure what you mean. This is a leveraged investment. If you buy a $100,000 home with $20,000 down and you sell the home for $120,000, you get $40,000. That's a 100% return. Of course if you buy a $100,000 home with $20,000 down and then sell it for $80,000 you will be left with nothing for a -100% return.

bigred77
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Re: Why 20% House Down Payment?

Postby bigred77 » Thu May 18, 2017 2:46 pm

monkey_business wrote:The standard advice for a down payment on a mortgage is 20%+. In the context of financially responsible individuals, such as Bogleheads, why is this the recommendation? Allow me to explain the various points that are making me question this advice:

- The money you have as principal in your house is at a risk of 100% loss until the mortgage is fully paid off. Even if you pay off the mortgage down to one last payment, if you fail to make that last payment, your equity goes to the bank in the event of foreclosure.

- Putting more money into the mortgage reduces the amount of interest that you pay. However, given the current low rate environment, and (in many cases) the mortgage interest deduction, isn't the money more likely to generate a higher return in a low cost index fund?

- The house appreciation/depreciation is not connected to your equity. In other words, the house will be worth what it will be worth, when you sell it, regardless of how much equity you have.

- Aside from saving interest, the equity, past the mortgage note length, is returning 0%, effectively losing purchasing power.

- 20% down avoids PMI. However, many companies (at least based on my research), offer PMI-free mortgages with as little as 5% down. In exchange, the APR on the mortgage is higher. The difference is usually 0.15%, at least here locally. The PMI ends up being far more than a 0.15% difference. Investing the additional 15% of the down payment into index funds seems to be a better idea long term than saving 0.15%/year on the mortgage.

That said, as I mentioned in the beginning of the post, this assumes the individual(s) getting the mortgage live below their means, and are Boglehead-ish. For the average person, 20% down is probably optimal.

What am I missing here?


20% gets you the best financing terms.

20% gives you some leeway to get out of a property (if you need to), even if the value drops a little bit, without the pain of bringing a check to closing.

I've seen multiple friends in LCOL places buy a house right after college and/or marriage with 3.5% down, use an FHA mortgage, have to move 2 years later, and then have to bring a check to closing even if they sold the house for the same price (or even a little higher) than they paid. They never internalized that they would be taking roughly an 8% haircut to sell the house in expenses.

dublin
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Re: Why 20% House Down Payment?

Postby dublin » Thu May 18, 2017 2:49 pm

Thanks OP for asking this question, I've been wondering similar things for a little while. Interested in the discussion.

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simplesimon
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Re: Why 20% House Down Payment?

Postby simplesimon » Thu May 18, 2017 3:20 pm

The required return for the difference in down payment is not simply the rate + 0.15% for a no-PMI loan because the higher rate applies to a larger mortgage.

For example, assuming a $500k house and 20% DP that gets you a 4.25% rate and a 5% DP that gets you a 4.40% rate...the investment would need to earn a return of at least 5.18% to beat the savings in the monthly mortgage. 5.18% risk free for 30 years is hard to beat.

Edit: Had to fix the math.
Last edited by simplesimon on Thu May 18, 2017 3:30 pm, edited 4 times in total.

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knpstr
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Re: Why 20% House Down Payment?

Postby knpstr » Thu May 18, 2017 3:25 pm

monkey_business wrote:The standard advice for a down payment on a mortgage is 20%+. In the context of financially responsible individuals, such as Bogleheads, why is this the recommendation? Allow me to explain the various points that are making me question this advice:

- The money you have as principal in your house is at a risk of 100% loss until the mortgage is fully paid off. Even if you pay off the mortgage down to one last payment, if you fail to make that last payment, your equity goes to the bank in the event of foreclosure. No, this is wrong. If for some reason you could no longer pay your mortgage you could just sell. If you had $1,000 left on the loan of a $300,000 house, you can sell the house, pay the $1,000 and keep the rest minus transaction costs.

- Putting more money into the mortgage reduces the amount of interest that you pay. However, given the current low rate environment, and (in many cases) the mortgage interest deduction, isn't the money more likely to generate a higher return in a low cost index fund? More likely I'd say yes, but maybe not.

- The house appreciation/depreciation is not connected to your equity. In other words, the house will be worth what it will be worth, when you sell it, regardless of how much equity you have. I don't know what this means. But a house follows the same rules as any other asset

- Aside from saving interest, the equity, past the mortgage note length, is returning 0%, effectively losing purchasing power. Again, I don't know what this means. But a house follows the same rules as any other asset

- 20% down avoids PMI. However, many companies (at least based on my research), offer PMI-free mortgages with as little as 5% down. In exchange, the APR on the mortgage is higher. The difference is usually 0.15%, at least here locally. The PMI ends up being far more than a 0.15% difference. Investing the additional 15% of the down payment into index funds seems to be a better idea long term than saving 0.15%/year on the mortgage. Seems to be, but may be not. You also have to count on your home value and situation to not change. If the home drops in value 20% and you have to sell for some reason, Your $300,000 house could now be worth $240,000 and you may owe $285,000. You can't sell or refinance your way out of this. You'd have to sell for $240,000 AND right a check for $45,000 to pay off the loan (or do a short sale or foreclosure or take out another loan or...)

That said, as I mentioned in the beginning of the post, this assumes the individual(s) getting the mortgage live below their means, and are Boglehead-ish. For the average person, 20% down is probably optimal.

What am I missing here? Essentially you're missing the risk inherent with debt particularly high debt (95%) and you're missing that a home behaves the same way as any other asset. There is also a "cash flow" element to the equation. Some people may prefer a certain house but want a certain monthly payment for budget reasons based upon their pay. Obviously, putting more down, lowers your monthly payment obligation. I don't know what points 3 and 4 even mean, but I'm sure if you took out a loan on your stocks to invest in more stocks the same would apply.
Very little is needed to make a happy life; it is all within yourself, in your way of thinking. -Marcus Aurelius

freebeer
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Re: Why 20% House Down Payment?

Postby freebeer » Thu May 18, 2017 3:31 pm

There is a standard for "conforming" loans that follow Freddie Mac / Fannie Mae guidelines and if you don't meet the standard the loan is not as easily salable by the originating lender = you will pay higher costs/interests (usually). While the size of loan limit is more well known there is also a loan-to-value limit of 80%. So it's not just a question of PMI being required or not (that is likely but not always going to be required by a lender). See e.g. https://en.wikipedia.org/wiki/Loan-to-value_ratio#USA . If you are in jumbo loan territory anyway then this may be less of an issue since you are then by definition already non-conforming.

Submariner1980
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Re: Why 20% House Down Payment?

Postby Submariner1980 » Thu May 18, 2017 3:57 pm

bigred77 wrote:
20% gives you some leeway to get out of a property (if you need to), even if the value drops a little bit, without the pain of bringing a check to closing.



You're bringing a check to closing regardless - whether that's the 20% at the closing when you buy the house, or to cover the value drop at closing when you sell the house.

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monkey_business
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Re: Why 20% House Down Payment?

Postby monkey_business » Thu May 18, 2017 5:13 pm

Thank you for the replies so far. I will respond to some of the questions:

Jags4186 wrote:
monkey_business wrote:- The house appreciation/depreciation is not connected to your equity. In other words, the house will be worth what it will be worth, when you sell it, regardless of how much equity you have.


Not sure what you mean. This is a leveraged investment. If you buy a $100,000 home with $20,000 down and you sell the home for $120,000, you get $40,000. That's a 100% return. Of course if you buy a $100,000 home with $20,000 down and then sell it for $80,000 you will be left with nothing for a -100% return.


In your example, the two outcomes are either a 20% gain, or 20% loss on the $100k borrowed, i.e. $20k. This happens regardless of what my down payment was. I could own 20% the house, sell for $80k, and I lose $20k out of pocket. I could own 5% of the house, sell for $80k, and I lose $20k out of pocket. The difference is that in the 20% equity case, I have an extra $15k tied up in an asset whose value fluctuates independently of the extra $15k, and as such, this $15k could be making money elsewhere.

dublin wrote:Thanks OP for asking this question, I've been wondering similar things for a little while. Interested in the discussion.


Sure. I can't be the only one thinking about this :happy

simplesimon wrote:The required return for the difference in down payment is not simply the rate + 0.15% for a no-PMI loan because the higher rate applies to a larger mortgage.

For example, assuming a $500k house and 20% DP that gets you a 4.25% rate and a 5% DP that gets you a 4.40% rate...the investment would need to earn a return of at least 5.18% to beat the savings in the monthly mortgage. 5.18% risk free for 30 years is hard to beat.


You are correct. The 0.15% would indeed be on the whole mortgage. I will consider this.

knpstr wrote:- The money you have as principal in your house is at a risk of 100% loss until the mortgage is fully paid off. Even if you pay off the mortgage down to one last payment, if you fail to make that last payment, your equity goes to the bank in the event of foreclosure. No, this is wrong. If for some reason you could no longer pay your mortgage you could just sell. If you had $1,000 left on the loan of a $300,000 house, you can sell the house, pay the $1,000 and keep the rest minus transaction costs.

The point I was conveying is simply the leverage. If you don't make payments, your equity is at a risk of great loss.

- The house appreciation/depreciation is not connected to your equity. In other words, the house will be worth what it will be worth, when you sell it, regardless of how much equity you have. I don't know what this means. But a house follows the same rules as any other asset

- Aside from saving interest, the equity, past the mortgage note length, is returning 0%, effectively losing purchasing power. Again, I don't know what this means. But a house follows the same rules as any other asset

See comment above about the $100k house example.

- 20% down avoids PMI. However, many companies (at least based on my research), offer PMI-free mortgages with as little as 5% down. In exchange, the APR on the mortgage is higher. The difference is usually 0.15%, at least here locally. The PMI ends up being far more than a 0.15% difference. Investing the additional 15% of the down payment into index funds seems to be a better idea long term than saving 0.15%/year on the mortgage. Seems to be, but may be not. You also have to count on your home value and situation to not change. If the home drops in value 20% and you have to sell for some reason, Your $300,000 house could now be worth $240,000 and you may owe $285,000. You can't sell or refinance your way out of this. You'd have to sell for $240,000 AND right a check for $45,000 to pay off the loan (or do a short sale or foreclosure or take out another loan or...)

This is true but assuming I did not put down the extra 15% by choice, I could cover the loss later with the same money.


alex_686 wrote:If you put 5% down and the market drops 20% you are underwater. This limits your options. Need to relocate for a better job? Upgrade to a large home because your family has grown? Those options are now off the table.

Submariner1980 wrote:
bigred77 wrote:20% gives you some leeway to get out of a property (if you need to), even if the value drops a little bit, without the pain of bringing a check to closing.


You're bringing a check to closing regardless - whether that's the 20% at the closing when you buy the house, or to cover the value drop at closing when you sell the house.


Exactly. You are not putting down an extra 15% by choice, i.e. you will have the money later, to pay down any outstanding debt.

bigred77
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Re: Why 20% House Down Payment?

Postby bigred77 » Thu May 18, 2017 5:57 pm

monkey_business wrote:
Submariner1980 wrote:
bigred77 wrote:20% gives you some leeway to get out of a property (if you need to), even if the value drops a little bit, without the pain of bringing a check to closing.


You're bringing a check to closing regardless - whether that's the 20% at the closing when you buy the house, or to cover the value drop at closing when you sell the house.


Exactly. You are not putting down an extra 15% by choice, i.e. you will have the money later, to pay down any outstanding debt.


Fair enough to both points above. It's just money you didn't put up on the front end.

I'm someone who really doesn't mind debt (if used responsibly and strategically). I'm in the "all money is fungible" camp so if I lived in a 300k house and a $1M portfolio I wouldn't really even care if I was underwater and owed 310k on the mortgage. Most people buying homes (especially first time home buyers) aren't in that position though. In addition to obtaining the best financing terms I think there is SOME sort of benefit to having that leeway to sell the house and walk away with a little pocket change. There's usually some event that is compelling you to sell in that situation, I suspect you would appreciate all the cash you can get your hands on.

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burt
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Re: Why 20% House Down Payment?

Postby burt » Thu May 18, 2017 6:24 pm

Just wondering.....
Who is lending money on a house with less than 20% down?
Seems like I've seen this before.......

burt

Keepcalm
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Re: Why 20% House Down Payment?

Postby Keepcalm » Thu May 18, 2017 8:53 pm

VA loans.

runner540
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Re: Why 20% House Down Payment?

Postby runner540 » Thu May 18, 2017 9:10 pm

burt wrote:Just wondering.....
Who is lending money on a house with less than 20% down?
Seems like I've seen this before.......

burt


burt, many many financial institutions do this all the time, backed by FHA/VA programs. According to the American Enterprise Institute's Housing Risk research, the median down payment is 5% for all home loans. Repeat buyers (not first time) have median down payments of only 10%.

(page 59 in slide deck) http://www.housingrisk.org/mortgage-ris ... 2016-data/


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