Are 20-Percent Home Down Payments History?

If you want a so-called “conventional” mortgage, lenders typically require a 20% down payment. A 20% down payment on a house is a lot of money, no question about it. If you have to make a 20% down payment on a $250,000 house, that means coming up with $50,000.

Many lenders will have no problem giving you a mortgage with a down payment of as little as 5% — or just 3.5% for a FHA loan (if you qualify) and some other government-insured programs. Of course, putting down less than 20% has its drawbacks.

So the questions are:

• Is a 20% down payment really necessary?
• How risky is it to buy a home with less than 20% down?
• Is it better to make a lower down payment (and have cash left over) or stretch yourself thin to put 20% down?

Here are the pros and cons of putting less than 20% down on a house:

Mortgage pricing is not as standard as it used to be. Mortgage lenders use risk-based pricing adjustments to produce the rate on your loan. They will factor in the type of loan you take (fixed or adjustable), the size of the loan, your credit score, and the size of your down payment, among other factors.

There are both positive and negative adjustments for each category. For example, the higher your credit score is, the lower your interest rate will be. The same is true with your down payment. You’ll generally have to pay a higher rate if you make the minimum down payment on a house, say 5%, than you will if you put down 20% or more.

This is because mortgages extended to buyers who make minimum down payments are considered to be higher risk than those offered to buyers making larger down payments.

On a typical mortgage loan, you might pay an interest rate that is .25% higher with a minimum down payment than if you made a 20% down payment. That may not seem like a lot, but if you borrow $200,000, it will result in an extra $500 per year in interest costs.

Related: See today’s mortgage rates from top lenders

Typically, when you buy a home with a down payment of less than 20%, you’ll have to pay private mortgage insurance, or PMI — and it’s not cheap.

Let’s assume you’re taking a 30-year fixed-rate mortgage for $237,500 with 5% down and you have a credit score of 700. Based on rates provided on the MGIC Rate Card, if you make a 5% down payment, your annual PMI premium will be 0.89% of the loan.

Your mortgage insurance premium will be calculated by multiplying 0.89% by $200,000, which is $2,114 per year. That will add $176 to your monthly housing payment.

Still another financial expense will be higher closing costs. Since certain mortgage closing costs are based on the size of your mortgage, and a smaller down payment will result in a larger mortgage amount, your closing costs will be commensurately higher.

Let’s look at one big closing cost, the origination fee. On a $250,000 house purchase with 20% down, your mortgage will be $200,000. A 1% origination fee will result in a $2,000 fee. But if you only put 5% down, your mortgage will be $237,500, and that will result in an origination fee of $2,375, or $375 higher.

There are several closing costs that will be similarly affected. For example, if you live in a state that imposes mortgage stamps, they will also be based on the size of your loan.

A lower down payment usually results in higher closing costs. But this may not be much of a factor if you live in an area where it is typical for the seller to pay the buyer’s closing costs.

Earlier on Money Under 30, we looked at how much cash you really need to close on a home. In many cases, the down payment is just the beginning.

We used an example of buying a $200,000 home with a 10% down payment of $20,000. When you add in closing costs and the cash reserves (money some banks require you to have on hand after the home purchase), the total money you need to close came to $31,000.

If making a 20% down payment is already a stretch, these additional costs and cash requirements may necessitate putting a smaller amount down.

Alternatively, you might be trying to buy more home than you can afford. Read more about determining how much house you can afford, or try our home affordability calculator.

Apart from the financial costs involved in making a minimum down payment, you are also adding to the already significant risks associated with homeownership.

Here are some of those risks:

• Should property values decline in your area, a 5% down payment could be wiped out quickly, leaving you in a negative equity situation.
• If you have to sell two or three years after closing, you may find that you owe more than the home is worth and will have to write a check just to sell your house.
• The loss of a job will make the higher house payment that comes with a minimum-down mortgage that much harder to manage; using our interest rate and PMI examples above, your monthly house payment will be nearly $200 higher with a minimum down payment.
• Since a minimum down payment keeps your equity to an absolute minimum, your options to refinance will be limited.

This is a popular position in the investment community. We at Money Under 30 don’t necessarily recommend it unless you’re a confident and aggressive investor, but it’s not entirely without merit, so let’s discuss it here.

The idea is that you make a minimum down payment on a house so that you have more money to invest in the stock market. Because of the high returns that the stock market can offer over many decades, this strategy may pay off.

Statistically, the stock market has returned about 10% per year since 1928 based on a performance of the S&P 500. (We realize the market has not been as favorable recently, but let’s be optimistic for the sake of this example.)

If you want to purchase a $250,000 house and you have $50,000 for a 20% down payment, you can choose instead to make a 5% down payment ($12,500) which would leave you with $37,500 that you can invest in a no-load index fund based on the S&P 500.

What does the first year using this strategy look like? A 10% average annual return on $37,500 would produce an average of $3,750 in annual investment income. But, since you’re making a minimum down payment, that return will be reduced by the extra costs of carrying a higher mortgage amount.

With 5% down, your monthly mortgage payment will be $218 higher than if you put 20% down ($42 for mortgage interest, plus $176 for PMI). That totals $2,616 per year, and reduces your annual return on your stock investments to $1,134. That lowers your return on investment from 10% to just 3.02%.

What about the results after 10 years? $37,500 invested at 10% for 10 years will grow to $97,265. But remember that we have higher carrying costs on the larger loan — $2,600 per year. That will reduce your investment balance by $26,000, chopping it to $71,265.

But let’s not forget about mortgage amortization. If you made the 5% down payment, your mortgage would be $237,500. This means your outstanding loan balance would be $234,026 after 10 years. Assuming that the value of your home remains level at $250,000, that would leave you with roughly $16,000 in equity. Combining that equity with your $71,265 investment balance gives you a combined worth of $87,265.

If you made the 20% down payment, your mortgage would be $200,000 and the loan balance would amortize down to $197,075 after 10 years. That would leave you with about $53,000 in equity in the home.

The difference between the two numbers shows that you would be ahead by about $34,000 if you put 5% down and invested the difference in the stock market.

But, as is always the case when it comes to investing, you also have to factor risks into the decision. Some of the risks involved in making the minimum down payment and investing the difference include:

• You may not have all of your money invested in stocks, thereby lowering your annual rate of return on your investments.
• The 10% average return since 1928 spans more than a human lifetime; in any given decade the number could be considerably lower — ask anyone who was in the market between 2000 and 2010, or during the 1970s.
• A stock market crash within the decade could change the entire equation dramatically.
• All the other risks associated with a minimum down mortgage will apply.

If getting double-digit returns on stocks were guaranteed, making the minimum down payment on a house and investing the difference in stocks would be a no-brainer. But life is never so neat, so you have to factor different risks into the mix and proceed accordingly.

In the end it may come down to nothing more than personal preference. The numbers favor making a minimum down payment and investing the difference. But that means putting your money 100% in risk investments (stocks) at the same time as you’re in a high-risk situation with your home (minimum equity). You may come out ahead financially, but you might not get much sleep at night.

Learn more:

Saving up for a downpayment? Use our resources to buy a home the smart way:

• How to best save for a down payment on a house
• Your down payment: Sources of cash to buy your first home
• Get mortgage pre-approval online
• Shop around for the mortgage lender that will give you the best loan for your needs