Should I make a big or small down payment?
December 04, 2012
Q: We are looking to buy a house, and face three options: We could put 20 percent down, but this would leave us with less than $10,000 in savings. We could get a 5-percent-down FHA loan, but this would require us to pay $500 per month in mortgage insurance for at least five years. We could also continue renting. The 20-percent option would result in a mortgage payment of $2,600 per month; the 5 percent option would result in a mortgage payment (including the insurance) of $3,500 per month. Currently we are paying $3,250 in rent. Which option seems best?
A: You are correct to be concerned about draining most of your savings, because it is always good to have some kind of cushion against adverse events. Still, juxtaposed against the prospect of paying an extra $500 a month in mortgage insurance (plus the additional interest you would accrue by taking out a larger loan), the 20 percent down payment might be the lesser of two evils. Factored over five years, $500 per month comes to $30,000, and that seems a steep price to pay for the comfort of keeping a larger cushion in savings. After all, on a cash flow basis, the 20 percent option would leave you with an additional $900 a month, so if you are disciplined enough to put this toward savings you could start rebuilding your savings account pretty quickly.
Another way to think of this is that with rates on savings accounts so low these days, you'll get little reward for keeping the money in savings -- certainly not enough to compensate you for $30,000 worth of mortgage insurance premiums.
That said, there are two specific aspects of your situation which could tilt the decision one way or another:
- How secure is your job? This is something to consider under any circumstances when buying a house. But in terms of your question, if you have any job security concerns, it would be an additional argument against depleting savings with a larger down payment.
- How readily could you afford a $3,500 monthly payment? The $900 differential in monthly payments under your two mortgage options would represent a significant difference in most people's budgets. If you have any concerns about being able to make such a large payment, it would tip the balance more in favor of the larger down payment.
Finally, continuing to rent while you saved up more money would make sense in many circumstances, but in this case a couple things argue against it. First, yours is quite a steep rental payment, so it doesn't really put you in a favorable position to save money compared with buying now. Second, current mortgage rates are extraordinarily low. Missing this historic opportunity in mortgage rates could turn out to be a very costly mistake.
On balance, things seem to point toward the 20 percent down payment -- as long as you feel secure in your job.
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