If you’re buying a house, and you’re not paying all in cash, you’re going to have to take out a loan to finance the purchase of the property. Before you can take out that loan, you’re usually required to submit a down payment – and you’ll have the independence to choose what type of down payment you want to make.
In many cases, it’s advantageous to submit a smaller down payment, for reasons we’ll explore in a moment. But is it possible for the down payment on a house to be too small?
The Role of a Down Payment on a House
Banks often require a down payment on a house as a show of financial stability. It’s a way of reducing the borrowed amount and a gesture that this person is financially responsible enough to at least save up a down payment; both of these aspects are signals of credibility. Additionally, the down payment gives the owner a stake of equity, or ownership, in the property.
It’s possible to purchase a house with a down payment as low as 5 percent – or even 3 percent – of the purchase price. However, many property purchasers submit down payments of 20 percent or higher; that’s because this threshold is usually required in order to avoid private mortgage insurance (PMI), an additional fee that banks will include in your monthly mortgage payment.
Some people view down payments as little more than a required formality that must be pursued, while others view it as their first opportunity to build real equity in the properties they purchase.
Why a Small Down Payment on a House Is Often Beneficial
Why is it that a small down payment is often beneficial for home purchasers?
- Immediate action. One of the most pressing and obvious advantages is that it takes less time to save up a down payment, enabling the purchaser to take immediate action – or at least, quicker action. If you want to save up a down payment of $5,000, you can probably do that in a matter of months or a few years. If you had to save up a down payment of $100,000, it might take you many years – or it may be an unrealistic goal for your situation. Working with smaller down payments means remaining more agile in the real estate market, which can help you score better deals and ultimately become more profitable.
- Financial leverage. Financial leverage is simply a financial advantage conferred by using someone else’s money. Offering a smaller down payment means borrowing more money, which means getting access to more value in real estate without having to put more of your own money in the pot. Financial leverage has helped countless people become millionaires and billionaires because it gives them earlier and faster access to investment money. That said, it’s important to remember that financial leverage isn’t strictly an advantage; there’s also a risk in borrowing money and taking on debt.
- More capital available for other needs. If you have lots of money saved up and you offer a smaller down payment, you’ll have more money that you can use for other needs. That could mean fixing up the property, marketing the property to renters, or getting an awesome collection of furniture for your new residential property.
The Advantages of a Bigger Down Payment
Before you get too excited about the prospect of making a small down payment, it’s important to remember that there are advantages to making a bigger down payment as well.
- Avoiding PMI. Remember, many banks are going to charge you PMI, artificially increasing your monthly mortgage payment, if your down payment falls below a certain threshold (usually 20 percent of the purchase price). In many cases, it makes sense to offer a bigger down payment for the sake of keeping your monthly payments lower and avoiding sending more money directly to the bank.
- More equity. A bigger down payment means you’ll have more equity in the house immediately. Equity is, fundamentally, a measure of your financial ownership in the property, so having more ownership means you’re going to have more exposure as the local market grows. More equity isn’t always better, but it can be advantageous in certain circumstances.
- A lower monthly mortgage payment. Your monthly mortgage payment is calculated in part by incorporating the principal you currently owe and applying interest to it. If you submit a bigger down payment, you’ll borrow less money, which means your principal and interest charges will be lower. In other words, you’ll have a much lower monthly mortgage payment.
- More financial stability. Forcing yourself to come up with a bigger down payment is a way of proving to yourself that you have more financial stability. Incidentally, taking on less debt is also a way of making yourself more financially stable. If you’re financially conservative, or if you just like to hedge your bets, it’s a good idea to consider making a bigger down payment.
Factors to Consider
There are many acceptable ways to approach a down payment on a house. There is no one right answer, so consider the following factors in your decision:
- Personal savings. How much do you currently have in personal savings? How hard would it be to save up a bigger down payment? How much would you like to allocate to other expenses, like repairs and maintenance?
- Credit and financial standing. What is your credit score like and what is your financial standing? The more assets and income you have, the more comfortable you should be taking on good debt, generally. If you’re in a tenuous financial position, a bigger down payment can bring you more stability.
- Income potential. How much income is this property going to bring in? If it’s a sizable money maker, you may be able to afford bigger monthly payments.
- Repairs and other expenses. Are you going to be responsible for many other expenses associated with this property once you acquire it?
- Market dynamics. How is the market moving? How do you anticipate it moving in the near future? If you can get more exposure artificially through financial leverage, would it benefit you? How much risk would it introduce?
- Your portfolio. How is the rest of your portfolio balanced? What are your overall risk tolerance and exposure to the real estate market like?
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