Introduction
Owning a home is one of the biggest milestones for some people. A place to own and call home is something many wish they could do, but are unfortunately not able to. When an opportunity arises, many people think about their life within the home they are buying, but do not think about the financial risk. Majority of the conversations that occur in the workplace, or outings with friends, revolve around a 20% down payment on a mortgage to avoid Private Mortgage Insurance - otherwise known as PMI. Due to hearsay opinions, this concept of 20% down on a house or the “wasted” money on PMI gets thrown around without much thought into the risk part of the decision.
Why do people put 20% down on a home?
Lender’s (majority are banks) have to protect themselves from taking on a huge mortgage liability. A homebuyer is required to put a minimum down payment of 3.5%. If a homebuyer is only putting 3.5% down then the lender has to finance 96.5% percent of the loan. On a million dollar home, the lender is financing a 965,000 dollar loan.
Private Mortgage insurance is a fee that the homebuyer pays just incase the homebuyer defaults on the loan. This extra payment is actually paying for the lender’s cost of the insurance because the bank is assuming majority of the risk. Unfortunately, this extra fee is not considered a write-off during tax time, which most see as wasted money.
A 20% down payment is required to remove the monthly fee of Private Mortgage Insurance. This is worth it for some people because it decreases their monthly expenses.
Who is taking on Financial Risk?
20% Down Payment Scenario
It is up to the homebuyer to decide what is best for their financial situation. For a million dollar home, one needs 200k to free themselves from PMI. 200k for most people is a hefty amount of money. In comparison to the lender, the lender is actually not taking as much financial risk if the homebuyer does this while depleting their emergency funds. The homebuyer may be putting themselves into financial risk if they decide to empty all of their savings. Loss of a job, unplanned events, or economic downturns can create a stressful living situation if they are not planned for. Any of these situations may also cause the homebuyers to default on the loan and may end up losing all of their capital. If the homebuyer has extra emergency funds, this may be the reason to get rid of PMI, but only if the downside risk is assessed.
3.5% Down Payment Scenario
The same homebuyer with 200k ,who is putting a 35k down payment, is actually at less risk overall, but their monthly payment will be higher than the person putting 20% down. Loss of a job, unplanned events, or economic downturn will not heavily affect the homebuyer who has 165k left in savings. If they default on the loan, the max loss on the home is 35k. The monthly payment will be higher because the PMI will be added until a certain threshold of equity is reached (usually 80% loan to value). Since the bank is taking on the majority of the risk, the consumer has the upper hand if things go south, but may also take a hit on their credit.
So which is better?
That decision is up to the homebuyer. Everyone has different financial liabilities, but it’s important to weigh the pros and cons of each situation when buying a home. As a rule of thumb, plan for your downside risk first - you already know the best case scenario.
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