PhilMur's thoughts on biz/tech/money/life

I read an interesting article the other day which reviewed a book written back in 2005 — the book was about the elimination of down payments and the related fraud in the mortgage industry that often allowed people to qualify for mortgages for which they would have not otherwise been approved (see the article by clicking here).  It basically puts mortgage fraud and $0-down mortgages in the same camp — they each existed because the other did.

Mortgage fraud aside, however, one still might ask “is there really anything wrong with a $0 money-down mortgage?”

If by “wrong” you mean something inethical or morally wrong, then probably not, of course.  If by “wrong” you mean ill-advised, then I would say YES it is ill-advised.  Many financial counselors and planners alike have recommended sizable down payments forever, and yet many (usually those looking to buy a house with little cash) write off the advice as “legalistic” or “not practical”.

Instead of chiding those of you who have taken the $0 down or minimal down payment approach (because I too have done the $0-down thing in my less-informed past, though I’m now free of such an arrangement), let me instead focus here on FOUR BENEFITS of saving for a down payment.

There are other issues with home mortgages of course – how long of a mortgage do you get, is it possible to put too MUCH money down on a house, etc. — but those I will save to discuss another time.  For now I’ll stick to my discussion on the benefits of saving up a down payment.

BENEFIT #1:  IT LIMITS THE AMOUNT OF HOUSE  YOU BUY TO A DOLLAR AMOUNT WITHIN YOUR BUDGET

There is some scary reverse psychology that most Americans have bought into (pun intended) that goes something like this– “the less I have to put down on a purchase (car, house, etc.), the better I can afford it!”.  In fact, the OPPOSITE is true.  The very fact you cannot save money to place down on the purchase should give you pause, and make you wonder if you can afford the monthly payments on the new purchase.

But when you force yourself to save money down for a house, you automatically limit the value of the house you can buy to the value of a house you can actually afford.  I, along with many personal finance coaches, recommend you save up a down payment of at least 20% of the home’s value, and preferably, another 5% or so to fund new furnishings, minor improvements, etc. that each new homeowner inevitably wants (financial planner Dennis Stearns, according to this article, claims new homeowners on average spend 3.6% to 4.5% of the value of a recently purchased home on improvements alone).  Note that this total 25% home savings should be beyond what you would hold in your emergency fund (typically made up of 3-6 months worth of expenses).  Some might argue that a base down payment of 20% (plus improvement/move-in costs) is excessive, and that one can lower their risk and mortgage payment by saving up 10% or 15%.  While that is certainly true, and while doing so is better than putting down no money at all, I explain below an additional benefit of saving a full 20% — avoiding the cost of private mortgage insurance, or PMI.

Let’s look at an example of how this actually works out.

A- Let’s assume your family has a household income of $75,000, resulting in net “take home” pay of about $55,000 (assuming a couple of kids and typical deductions).

B- You would like to purchase a house in an area that will cost you somewhere in the range of $200,000.

C- According to my recommendation, you would need to save up about $50,000.  If you as a family are able to save 15% of your take-home pay, or $8,250, then at that pace if would take you about 6 years to save up for a down payment.

D- If that makes you say “yikes, six years!” then you can either attempt to save up more quickly, or scale down your plans in terms of price/size of house.  If you instead aim at a $150,000 house, you could save up the 25% for down payment and initial expenses of $37,500 in about 4 1/2 years.  Cut spending and save a bit more, for example save 20% of your take-home pay ($11,000 per year) and you could have 25% of a $150,000 house saved up and be ready to buy such a house in about 3 1/2 years.

Ultimately, most people will find that the closer to 2 or 2.5 times their annual gross income the price of their house is, the more likely they will be able to save for a down payment, and then make the payments on that house successfully.

Unfortunately, the mortgage world is still full of lenders that will loan you 95% or 100% of the value of your house and who would often like to sell you a house costing 3 to 4 times your annual gross income.  Think about it – mortgage brokers are typically paid a percentage of the loan amount, so the more they can get you to borrow, the better off they are!

BENEFIT #2:  IT LOWERS THE CHANCE THAT FUTURE FINANCIAL DIFFICULTIES WILL DEVASTATE YOUR FINANCIAL WORLD

When you have 20% or greater equity in your home from day one of your ownership you lower the odds that your mortgage payment will contribute to future financial devastation of your family.  There is both a direct and indirect reason for this:

INDIRECTLY, by getting into a financial position of saving for your home purchase, you are unlikely to fall behind on your mortgage payments due to overspending as you had to create a disciplined financial environment in your family in order to save for the purchase to begin with.

DIRECTLY speaking, with ownership in a home that is worth substantially more than the debt you have on it, you have a “cushion” of net worth that can be accessed.  Although equity loans are certainly available and though I recommend against them, the main thing I have in mind here is that should severe financial difficulty affect your family (such as a loss of all family income), and you burn through your several months of emergency funds and are still struggling, you could sell your home quickly at a good price and still come out with some cash in hand.  Families who owe almost as much on their home as its value of their home, or who owe even more than the home’s value, put themselves at significant risk in the event their income drops or disappears altogether.  Another DIRECT reason for the benefit of having equity in your home is that, in the event that life circumstances change and require you to move to another part of your city, or another city altogether, it is unlikely that property values will drop by more than 20% and so even though it will not be pleasant, you WILL be able to sell your house if you absolutely must.

BENEFIT #3:  IT LOWERS YOUR MORTGAGE PAYMENT!!

See the chart to the right, which demonstrates the difference in monthly payments (loan principal + interest only) on a mortgage with 20% down as compared to 5% down (assumes 5% interest rate and a 15-year term).  Note the substantial payment difference with the home values ($150,000-$200,000) used in our example above — there’s hundreds of dollars of monthly difference in the payments!  And of course the difference grows even larger as the size of the home grows.

This is an obvious benefit that I don’t think many people think about when weighing the idea of a small vs. a more substantial down payment.  However, it should be one of the leading factors to consider!  This is because, although during the period of time in which you save up for your house down payment there could be some fluctuation in your budget and savings from month-to-month, once you’re locked into a mortgage, there will be no mercy coming from your lender — you’ll have to make the payment every month.  If you’re going to be locked into a large monthly payment for probably at least 15 years, doesn’t it make sense that the payment be smaller if you can help make it so?  The only other way to shrink the size of your payment is to a) go for a less expensive home– a good solution for some, or b) use a longer-term mortgage — not as good of a solution but also not a topic I will get into here.  Finally, it is also critical to understand that by having a loan amount of 95% of the value of a $150,000 home, you will pay about $32,000 more in total over 15 years for the house (as a result of the extra interest on the extra borrowed amount) than you would with a larger 20% down payment.

The bottom line on my third point here is this:  every dollar saved NOW for a down payment on a house is a dollar that you won’t have to pay someone later– with compounded interest.

BENEFIT #4:  YES, IT ALSO ELIMINATES THE COST OF PRIVATE MORTGAGE INSURANCE (PMI)

Private Mortgage Insurance, or PMI, is a type of insurance lenders require homebuyers with small down payments to acquire in order to protect the banks against the chance the home buyer will be unable to make their mortgage payments.  The fact that a bank would require you to buy insurance to protect them from you should raise red flags — because THEY apparently believe the odds of you at some point losing your ability to pay your mortgage are higher odds than YOU think they are, if you’re willing to get a mortgage despite this extra requirement!

PMI, according to AppraisalToday.com, is typically required when a home buyer brings a down payment of less than 20% of the home’s value.  To illustrate the cost of PMI, the same source says that with 5% down, you would pay about $70 per month for PMI on a 30-year mortgage on a $119,000 home.

This cost can be completely avoided with a down payment of at least 20%.

Unfortunately, in recent years when people talk about “avoiding PMI” they are typically promoting an arrangement involving a 80% primary mortgage and a second mortgage ranging from 15-20% of the remaining value, thereby removing the need for PMI.  For those who have taken this approach, however, they realize that they pay a higher rate of interest (often at variable rates that adjust periodically) on their second mortgage, and typically incur additional financing-related fees at the time of purchase.

CONCLUSION

It is challenging, from a purely financial and risk reduction standpoint, to make an argument for little-or-no-money-down home loans.  And yet, the mortgage industry has made such an argument to do so convincingly, in an effort to drum up more of the commissions and fees they generate for originating a mortgage.  The sub-prime collapse and housing market meltdown in general in recent years has brought this further to the forefront of public understanding, and yet mortgage products featuring little or no down payments are still prevalent today for those with decent credit and income — and so do not assume the marketplace is protecting everyone now from every bad financial product out there; I would encourage each of you to think twice before embracing such products.

Chances are, those of you who have bought homes with little or no money down (or are considering doing so) are not making the decision based on numbers or risk, either.   It’s an emotional decision for you; you WANT a new home and so you’re willing to ignore the risks to get into that new home.

But I can assure you this — if times get hard for you financially after doing so, the grief that will come from the financial stress of a mortgage payment on a house you can’t afford the payments on, and can’t sell because you owe as much as it’s worth will far outweigh the joy of that new kitchen with granite counter tops and crown molding.  Why put yourself through years of stress trying to get out of the house or make money to stay in it?  Instead of suffering later, sacrifice NOW for a few years to avoid such a situation.  I promise that it will be well worth it!