Your Down Payment: An Important Decision

Eric Mager

There are few important things to consider when deciding on a down payment amount.

In an earlier article, we walked through the six most important home-buying decisions. One of them is figuring out a down payment amount that is right for you. Your down payment, along with your monthly mortgage payment, will determine how much home you can afford.

A down payment is an amount you pay up front on the day you buy your home. If the home price is $300,000 and you borrow $240,000 (your mortgage loan amount) from a bank, you’d need to make a 20 percent down payment of $60,000 ($300,000 home price – $240,000 mortgage loan amount) to make up the difference.

Equity

Don’t worry, that $60,000 didn’t disappear. It’s still yours – it’s your equity in the home on the day you buy it. Equity is the value of your home minus the amount of your mortgage.

An asset is something that you own. Your home, car, stocks, cash, and 401(k) are all assets that you own. When you make a down payment, you’re shifting $60,000 from a liquid asset, cash, to a less liquid asset, equity in your home. An asset is more liquid if it is easier for you to convert to cash.

The equity in your home is less liquid than cash because if you needed to access your equity, you’d need to sell your home, which might take a few months. If you needed to access cash, on the other hand, you could simply write a check or drive to the bank and make a withdrawal.

You can also access your equity by taking out a home-equity loan (HELOAN) or a home-equity line of credit (HELOC), but remember that you’ll pay interest when going this route.

As the value of your home increases and your mortgage loan amount decreases, your equity increases. If, after one year, the value of your home has increased to $315,000 and your mortgage loan amount has decreased to $236,500, your equity would be $78,500 ($315,000 – $236,500).

Transaction Costs

In addition to the amount of time it takes to access your equity, you also need to consider transaction costs. In our example, your equity increased by $18,500 after one year ($78,500 – $60,000). Awesome, right? Let’s sell the house and pocket those gains! Not so fast. There are a few other things to consider.

When you sell your home, you’ll typically pay a real estate agent a 6 percent commission. In our example, the home is now worth $315,000. The commission would be $18,900 ($315,000 X 6 percent). In this example, the commission alone offsets your gain in equity.

There are other costs as well, such as closing fees for the house you are selling. You’re also likely to buy another home, and then you’ll pay mortgage origination fees and other associated costs, including appraisals and mortgage insurance.

There are also the costs of moving, which include monetary ones (like paying for a moving truck) as well as nonmonetary ones (like spending an entire week packing and dropping the washer on your toe).

Setting Aside Some Savings

In general, the higher your down payment, the lower your mortgage costs will be. For starters, making a larger down payment simply lowers the amount you are borrowing for a given home price. Additionally, a higher down payment can lower or eliminate your mortgage insurance and decrease the interest rate on your mortgage, because banks experience lower losses on mortgages that have a higher down payment. Home buyers with a higher down payment have more skin in the game.

Although increasing your down payment lowers your mortgage costs, don’t take your bank account to $0. Bundle has easy-to-use monthly payment and down payment calculators that can help you with your decision. Here are some things to think about in setting aside some of your savings.

Monthly Expense Cushion

You should always set aside an amount of money for paying your bills if something unforeseen happens. You may lose your job or you may need to take a leave of absence to care for a family member. Figure out how much you would need for all your expenses for three to six months. You can use Bundle’s budgeting tool to help with your monthly expenses.

If your total monthly expenses add up to $5,000, it’s a good idea to set aside $15,000 to $30,000 (three to six months). If you were to lose your job, you’d be able to use these savings to pay your bills and stay current on all your loan payments. This helps you maintain your credit score and eliminates the risk of losing your house to foreclosure.

Other Closing Costs

Many first-time home buyers mistakenly assume they’ll only need to write a check in the amount of their down payment at closing. There are quite a few other costs that can quickly start to add up. It’s important to account for these when determining your down payment amount. These costs are detailed on the second page of the loan estimate and may include the following:

Origination charges: These are other fees that a bank may charge in addition to your interest rate. They may be called processing fees, origination fees, discount points, underwriting fees, or application fees. Don’t worry about the difference in these – just make sure you add them all together.

Title insurance: This item can seem a little complicated to a lot of home buyers. In simple terms, when you buy a property – your home and the land it sits on – it belongs to you; no one else can claim it. Title insurance helps ensure that this is true. It protects you and the bank from issues arising from defects in the title or the unenforceability of the mortgage. You can read more here.

Escrow account reserves: These are prepaid items that are often required and that are used to start your escrow account with a balance. An escrow account is an account that the bank will use to pay property taxes, mortgage insurance, and hazard insurance on your behalf.

Appraisal fee: When a bank loans you money in the form of a mortgage, it wants to make sure that the home you’re buying is worth what you’re paying. In order to validate this, they’ll pay a third party to assess the value of the home. It’s common to pay this fee before closing, but it will still show on your closing documents as a charge.

Other fees: These may include those for a flood certification or a credit report.

Lender Credits

Banks may offer to pay for your closing costs. This can be done by giving you a lender credit. This is not free money. You’re simply paying for this credit in the form of a higher interest rate. Ask your loan officer what your interest rate would be with and without a lender credit.

Other Large Expected Expenses or Savings Goals

Are you getting married, or do you have a big trip planned? Are you planning to buy new furniture or have repairs done once you move in to your new home? Think through these before you decide on a down payment amount.

The Final Number

Here is the example given in our article “The Six Most Important Home-Buying Decisions”:

Let’s assume you have $50,000 in your savings account. It’s a good idea to set aside three to six months’ expenses as a buffer if something unforeseen happens, such as losing your job or having to care for a relative. In our budget example above, your monthly expenses were $5,500 ($4,000 for your non-housing expenses + $1,500 for your mortgage payment). If you were to set aside three months’ expenses, $16,500 ($5,500 X 3), you’d have $33,500 left ($50,000 – $16,500). And in buying a home, you’ll most likely have expenses in addition to your down payment, such as your contribution to the mortgage escrow account and the cost of title insurance. Let’s say those add up to $3,500. You are left with $30,000 ($33,500 – $3,500) that you can use for a down payment.

Homebuyer