How Much Should You Allocate as a Down Payment?
A long time ago, people put 20% of the purchase price as a down payment when buying a home. You would pay this 20% upfront as a "cash" down payment through a cashiers check or by wiring money to the seller, and get a mortgage to pay them the remaining 80% of the price of the house.
These days, very few people expect the optimal 20% down payment. As a borrower, you have choices that provide you greater financial flexibility, or more stability at a higher upfront cost.
Loan-to-Value (LTV) Ratio
Lenders like larger down payments because it reduces their risk. Putting more of your money into a deal is a sign that you are committed: you as a borrower are less likely to cut and run because you have put up a significant amount of cash upfront to buy the house. You'd lose that investment along with the house if you ran.
Larger upfront down payments also help the lender minimize their potential losses. If you stop paying a mortgage, the lender may write off the loan, foreclose and then try to resell your house. But they can't always get full market value, so the smaller the loan amount, the better. If the loan is much less than the actual value of the house, the lender stands a better chance of profiting, or at least breaking even, if you walk away from your mortgage.
The amount of the loan as compared to the actual value of the house is called the loan-to-value (LTV) ratio. In this example, if you put 20% down, the LTV is 80%. This is the norm when getting a mortgage.
Less Than 20% Down
If you want to put less than 20% down (resulting in an LTV higher than 80%), you have a couple options. The first is to get a "piggy-back" loan, where you take out another loan to pay the down payment. This loan will usually have a higher interest rate than your primary mortgage.
Your second option is to pay for private mortgage insurance (PMI). This insurance protects the lender if you stop paying your mortgage. Your PMI can be tax-deductible like your mortgage interest in many instances. Please check with a professional in the area.
Some lenders will even allow you to borrow the entire purchase price of a house (100% LTV). You pay a premium through higher interest rates when choosing this route and you incur a significant risk. If your house goes down in value, you could sell your house and still owe money to the lender. This is known as negative equity and while it does happen to real estate, it's more common in cars where there is massive upfront depreciation.
When you make a down payment, your loan is less than the value of the house so you have some padding should you need to sell your house if it goes down in value. Without a down payment, your padding becomes any money you have saved up for a rainy day. 100% LTV is a powerful tool but you need to understand the risk.
A more common scenario is 10% down (90% LTV) where your "piggy-back" loan is actually a fully-utilized home equity line of credit (HELOC). As you payback the HELOC, you can use the available credit much like you would a credit card with a lower interest rate. Again, HELOCs are debt and the interest charges can be significant, but they are another tool if you're disciplined with your finances.
The Thought Process
If you go into the mortgage process expecting to put down 20%, you'll generally start with some of the better rates available from that lender. The trade-off is that many people find that it requires a large upfront investment.
Under 20% down payments are common but it's good to start your investigation there so that you understand what your lender is willing to give-and-take. From there, you can compare what you pay if you put less down.
This cost may include slightly higher to higher interest rates for your mortgage and "piggy-back" loan, as well as PMI. You're getting a good deal if the difference is small.
If your credit card debt is significant, please consider paying that off before purchasing a house so that you can be more assured of living in whatever house you buy for a long time. Real estate agents have to sleep at night too!
Interestingly, some lenders will give you a discount on your interest rate if you put down more than 20%. (This difference in LTV should not be confused with paying points. When you pay points, you're buying a lower interest rate for the same loan amount. When you make a larger down payment, your loan amount is less and the lender may reward you with a lower rate.) A quick analysis of the cost savings vs. your goals will help determine if this choice is worth the reduced financial flexibility.
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