Should I Wait to Buy until I have a Bigger Down Payment?
In an ideal world we’d all have the full 20% down-payment when we buy a home, and hence avoid paying Private Mortgage Insurance (PMI) on top of the monthly mortgage payment.
But saving that money takes time, which is time for the mortgage interest rate to potentially increase and for home values to appreciate further.
First let’s deal with mortgage rates and the buying power that a particular mortgage rate gives us.
For example: We are hoping to buy a home and keep our mortgage payment at or below $1,500 a month (not including real estate taxes or home insurance).
When we start saving, the interest rate on a 30-year fixed loan is 3.75%, and from that we know that we can buy a $400,000 home if we have the $80,000 down-payment (20% of the home value).
But what happens if the interest rate rises whilst we’re saving up the $80,000?
The table above shows what happens to our buying power at different interest rates.
If the interest rate increase by a quarter of a point to 4% whilst we're saving our $80,000, we can now only afford a $390,000 home and keep the mortgage payment at or below $1,500 a month.
That's 2.5% less home.
If the rate increases by half a point, we'll be buying 5% less home.
What happens if we have a smaller down-payment?
To avoid having to wait for the 20% down payment, we could buy a home once we have three quarters of that amount, or a half, or a quarter, or even an eighth.
But what does that do to our buying power?
Let’s look at another table to find out.
Note that PMI is included in each example monthly mortgage payment except for the column on the far left, where there is a 20% down-payment.
If we buy a home now with less of a down-payment, but still intend to keep our mortgage payments at or below $1,500, we end up buying less home.
We get 6.3% less home if we only have $60,000 and 12.5% less home if we only have $40,000.
This is partially due to having less equity at the beginning and partially due to the PMI payments.
PMI payments are not paid forever, though, so if you budget for them separately, knowing that they eventually go away, and only compare the mortgage payments themselves, the effect is less severe.
The next table illustrates this.
If we can budget for the PMI separately from our desire to keep our mortgage payments at or below $1,500 then we still end up buying less home if we have less of a down-payment, but the effect is less severe.
We get 5% less home if we only have $60,000 and 10% less home if we only have $40,000.
Note that this is only possible if we are buying a home that is not at our absolute maximum buying power.
If we only consider the chance of a mortgage rate increase when deciding whether to buy now or wait until we have the full 20% down-payment, then our decision should be based on how long it will take us to save and how much we think the mortgage rate will increase in that time.
As an example from the tables above, if we have $60,000 already, we could either buy a $375,000 or $380,000 home right now, depending on whether we can absorb the PMI or not.
Or we could wait to save the $80,000.
If the mortgage rate increases by half a point, we’re no worse off to wait than if we buy now (we’d be able to buy a $380,00 home).
If it increases by less than half a point, we’re better off waiting.
If it increases by more than half a point, we’re better off buying now.
But the mortgage rate isn't the only factor we need to consider: we also need to consider the possibility of home value appreciation.
If it takes another year to save up the down-payment, the example $400,000 home would have appreciated in value by $14,800.
Unless we can come up with all of that extra cash, we can’t buy the home and keep our mortgage at or below $1,500 a month.
Otherwise, we would have to buy another home, that is now worth $400,000, which would have been worth $385,728 a year earlier.
So we’re buying 3.6% less home.
If we have to wait 2 years, we end up buying 6.1% less home.
If we only consider either a potential mortgage rate increase or potential home value appreciation, in isolation, waiting can be costly.
If we consider both a potential mortgage rate increase and a potential home value appreciation, waiting starts to look more and more risky, financially.
The table above takes into account a projected mortgage rate for 2018 of 4% (a quarter of a point increase on what we have now) and a projected home value appreciation of 3.7%.
Waiting a year makes almost no financial difference in this example.
And if the rate increases by more than a quarter point, or home values appreciate by more than 3.7%, waiting will result in us buying less of a home a year from now than we could buy this year.
Whilst saving a full 20% down-payment, and hence avoiding PMI, can make financial sense, waiting to do so can be costly in the long run.
If it takes more than a year to save up the full down-payment, it might be better to buy now, pay the PMI and save more (if possible) to pay down the mortgage quicker.