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The 20% fallacy: Why you do NOT need 20% down — or do you?

07/11/2016

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One of the most persistent myths still making its rounds is that you need 20 percent down to get a mortgage.

In fact, you have not needed 20 percent down since FHA went into business in 1934. In recent years, as lenders scramble for millennial borrowers, low down payment programs have proliferated like rabbits, including thousands of state and local assistance programs and conventional offerings from Wells Fargo, Bank of America and Fannie Mae, among others.

You have not needed 20 percent down since FHA went into business in 1934.

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It’s no surprise that last year the average first-time buyer put down only 6 percent of their home purchase, and the average repeat buyer put down 14 percent. Veterans using VA loans, rural residents who qualify for USDA home loans and borrowers who take advantage of local down payment assistance programs have no down payments at all.

Pay them now or pay them later

However, the 20 percent down payment threshold is not a complete myth. You do need to put down at least 20 percent (or in mortgage-speak, have a loan-to-value ratio of 80 percent or less) to avoid paying mortgage insurance, which is required by lenders to protect them in the event of a default.

Saving on a down payment by taking out a loan that requires a monthly mortgage insurance payment is a pay-me-now-or-pay-me-later deal.

Taking out a loan requiring mortgage insurance payments is a pay-me-now-or-pay-me-later deal.

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You’d get into the house for a lot less cash up front, but you’ll be paying more every month to a mortgage insurer. You’ll be required to carry mortgage insurance until you have reduced the balance of your mortgage by 20 percent through the portion of your monthly mortgage payments that go toward paying off your balance.

Alternatively, you can speed up the process by paying more than the monthly minimum on your mortgage.

Is mortgage insurance bad?

Because the mortgage insurance protects the lender, not the buyer, many buyers go to great lengths to avoid it. However, is it so bad?

If you have a conventional loan on a $200,000 home with a 5 percent down payment ($10,000), you’ll pay $1,036 a year in mortgage insurance, or $85.50 a month.

Assuming a 0.41 percent rate for the insurance, excellent credit and a 30-year loan at 4 percent interest, it will take nine years before you can cancel your mortgage insurance — unless you pay more than your minimum mortgage payment each month. (This calculation was done using this calculator.)

As an extra bonus, you can deduct your mortgage insurance payment from your federal taxes for 2016.

Congress must reauthorize this deduction each year, so check with your lender or your member of Congress to find out if the deduction for mortgage insurance payments is still in effect when you do your taxes.

Mortgage insurance is higher on an FHA loan than a conventional loan. The monthly fee is based on a 0.45 percent interest rate for a 15-year loan and 0.8 percent for a 30-year loan; FHA also charges an upfront mortgage insurance premium of 1.75 percent of the base loan amount.

On the example above, the monthly FMA mortgage insurance payment for the first year would be $136.71 plus an upfront payment of $3,377, which the lender who is making the FHA loan rolls into the monthly payments over 30 years.

FHA insurance cannot be canceled, but it can be eliminated by refinancing when the borrower has sufficient equity. (This calculation was done here.)

Mortgage insurance is higher on an FHA loan than a conventional loan.

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Plusses and minuses of low down loans

Like most things in life, low down payments have their benefits and disadvantages. For first-time buyers who cannot assemble a 20 percent down payment but who want to get into a home today — while rates are still low and before prices climb higher — a low down payment mortgage might be the only way to go.

There are thousands of options today for low down payment and even no down payment programs: conventional mortgages; government programs — such as FHA, VA or USDA — and down payment assistance programs.

The negatives associated with low down payment programs — like mortgage insurance and a slower start on building equity — disappear with time.

Move-up buyers, after cashing in their equity when they sell their existing home, usually use their profits from the sale to make a down payment of 20 percent or more when buying their new home.

They avoid paying mortgage insurance and get a head start on building equity in their new acquisition.

For any first-time buyers who can afford to do so, putting down 20 percent is still a good idea.

Steve Cook is editor and co-publisher of Real Estate Economy Watch. Visit him on LinkedIn and Facebook.

Email Steve Cook.

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