Your Mortgage Down Payment: Why Pay Less Than a 20%

Mortgage in St. GeorgeConventional wisdom in the Beehive State tells you it’s advantageous to put down 20% of the property’s sale price in a mortgage. In many ways, this holds true: it renders you a less risky borrower to lenders, it essentially eliminates PMI, it reduces your loan amount to save in interest over time, and it could qualify you for better rates.

At a glance, paying one-fifth of the real estate’s purchase price out of your pocket makes financial sense. It’s even a heroic act to take a serious time to save and not hastily apply for a mortgage, and you think you’d be reward with your sacrifice. But this isn’t always true.

Unfair as it may seem, but it may even work against you, unfortunately.

Rate of Return

Other than your home, you must look at your property as an asset as well. Under the right economic conditions, it would appreciate over time. This means you’re passively building your wealth just because you pick the right location.

But the larger your down payment, the smaller your gains. Irrespective of your down payment size, your home’s value would increase or decrease the same way.

So if you put down, say, $84,000 (20%) on a $420,000 property, and it grew at 8% in just a year, your rate of return would just be 40%. Unlike when your down payment is $21,000 (5%), your rate of return would be a staggering 160%.

Illiquidity

Cash is a liquid asset, which means it can easily be withdrawn and spent. But if you use it for down payment, it quickly becomes home equity — an illiquid form of asset. Although home equity is factored in to calculate your net worth, you can’t use it for anything in the hour of need.

Any mortgage company in St. George, Provo, or Salt Lake City would tell you that you could only convert it back to cash by either selling the property or taking a cash-out refinance. In addition, both transactions would cost money to some extent.

Risk of Foreclosure

One of the main motivations for putting down an oversized down payment is avoid being in a negative equity position. In the event the real estate market crashes, house prices could sharply drop too. If you have plenty of equity, you could keep your head above the water.

However, most homeowners don’t realize that lenders are less keen to foreclose properties with no equity. On the contrary, if you default and face the brink of eviction, your lender may be less eager to foreclose your underwater property because of the substantial loss he or she would have to absorb.

Paying a down payment is certainly beneficial in many ways, but be conservative with its size. If you don’t think prudently, you might unnecessarily pay cash on your property and suffer in the end.