Q: I have over 20% of my home value saved. How much of a down payment should I put on my house?
This is a question I often receive. I’ll tell you how a lower down payment can have a big impact on your long-term wealth. This is one of the many strategies that I have employed that have taken my net worth from negative, to over $1 Million in ten years.
It comes down to 3 factors:
- How much can you afford on a monthly basis?
- Do you understand the opportunity cost of having money tied up in equity instead of invested?
- How disciplined are you in sticking to your wealth plan?
Most people think that by putting more money down and lowering their monthly payment, it makes it more affordable. I think 20 years ago, this was an accurate statement, but it no longer applies in today’s interest rate environment. If you’re needing to put 20% down to afford the house, its probably too expensive. If the strain of the monthly payment at 5% or 10% down is too much, this is probably a symptom of too much house and not having an ability to be net positive in your savings rate into other investment vehicles (401k, Roth IRAs, etc).
Opportunity cost is the most important factor to consider. Most likely, your home is going to appreciate over the long-term. So the value of the top line of your house will increase. By understanding opportunity cost and leverage, you can get the most bang for your buck from your money. Whether you put 5%, 20%, or 50% down, your house will appreciate at the same rate. If you are buying a house that you can afford, and still maintain your other savings rates, having a huge chunk of money tied up sitting in equity and not appreciating will actually hurt your wealth building strategies. You have to calculate the opportunity cost of not investing that difference of 20% down payment versus 10%. If you’re buying a $500,000 house, that’s deciding if you want an extra $50,000 sitting in equity, not earning anything, and investing that money. Sure, putting that extra $50,000 down will eliminate the need for Personal Mortgage Insurance (PMI), but PMI rates are very low. Even at the high-end, you’re looking at $60 per month. That’s $720 per year. Quick math tells us that you would need to earn 1.44% on the 50,000 to pay for the PMI. That should be no problem. The second part is the interest on the 50,000. At 3% interest, which is high in today’s environment, that’s another $1,500 in gross cost. However, with interest being tax deductible, it really should cost you $1,200.
Let’s summarize cost and then we’ll get to opportunity cost. In our assumption, we have $720 for PMI and $1,200 for additional interest expense, for a total of $1,920 or 3.9% of the 50,000. Now that we have cost established, its time to talk about the bigger cost, the opportunity cost. Putting that $50,000 into a stock index fund, like Vanguard Total Stock Index (VTI), it has had a long-term return of 8.9% since its inception, and that includes the dot-com and great recession. So you’re looking at investing at 8.9% versus interest and PMI costs of 3.9%. Even if the returns on an index fund were taxable, it is still a healthy margin that you can pocket on a yearly basis, and generally more if you have a long-term view.
The last part is discipline. Can you trust that the plan is working? Can you focus on long-term wealth, and retiring years earlier than you could if you had put that $50,000 down. Can you hold your wits if the market has a down year, even if it happens right away and your $50,000 is suddenly $35,000 a year later, due to a recession or a pandemic? Can you stick to the plan knowing that if you wait, history tells us that this plan works?