What a difference a year makes! The days of obtaining a 3% 30-year fixed mortgage are seemingly a thing of the past. With interest rates skyrocketing, many potential homebuyers are left wondering what’s next. A 30-year fixed mortgage has DOUBLED from a low of 3.15% in January to 6.3% in September. Mortgage rates have not been this high since 2009!
Rates effectively moved to a 13-year high in a span of nine months. The Federal Reserve, hell-bent on fighting inflation, has pledged to continue raising rates until a “terminal rate,” or endpoint, of 4.6% in 2023. This strategy comes with risks, and many, myself included, think the Fed needs to adopt a more flexible mandate. The impact of rate hikes of this magnitude can shock the economic system.
The Federal Reserve has completed a 180, going from a decade of loose monetary policy and artificially low interest rates to tight monetary policy and aggressively rising rates. This turnaround undoubtedly will impact the global economy, specifically the housing market.
When looking for a house, a low mortgage is always desirable. The lower the balance, the lower the monthly payment. With mortgage interest rates at or below 4% for much of the past decade, a mortgage was more “affordable” to the masses.
However, with interest rates sharply rising, potential new homeowners are realizing just how big of an impact the increase will have on their mortgage payments. The question is: What is an appropriate amount to put down? Unfortunately, there is not a “one size fits all” approach here. You will find many reasons why a higher down payment would benefit you in the long run, but you will find some cases where it wouldn’t.
Rising Mortgage Rates
Purchasing a home is a life milestone. For much of the past decade, homebuyers didn’t have a big incentive to put a large amount down, as the mortgage payment was manageable. In addition, the idea was to finance a majority of the amount and “invest” the difference over time in a more tax-efficient manner, with a high likelihood of making a larger investment return compared to the low fixed mortgage rate.
While we know the reasons why mortgage rates have been on the rise, one thing is clear: Ownership is much more expensive. Increases in mortgage rates can have a sizable impact on the monthly mortgage payment. To help put things in perspective, let’s look at an example below.
Source: Washington Post.
The difference between a 3% and 6.3% rate on a $450,000 house with 20% down ($90,000) is a payment amount of $710/month. This is ~$256,000 of interest over 30 years! This is a staggering amount, and it prices many people out of the market.
This is where a higher down payment can help. In the example above, putting 30% down on a 30-year fixed mortgage at 6.3% would reduce the monthly payment by ~$278/m compared to putting down 20%.
There are also other costs to consider. It should be noted that closing costs are typically calculated off the purchase price, while the lender’s charges and other fees are typically based on the loan amount.
It is important not to force the issue. A home is a big commitment, and feeling comfortable with the down payment and mortgage is vital. If you only think you can afford a higher payment, then you should think twice before proceeding.
Lower Interest Rates
Another benefit of a larger down payment is that you’ll generally qualify for a lower interest rate. The lender’s rationale is that you are a lower “risk” since you have more stake in the property and will have a better equity-to-debt ratio.
If you can put more money down, it’s worth considering. The larger the amount, the better your interest rate will be. This can be especially helpful if you’re trying to get a mortgage when mortgage rates are rising while home prices are falling.
Putting less down and investing the difference is a riskier proposition in a rising-rate environment. Unless you confidently feel you can earn well north of 6% investing in the market, it would behoove you to allocate a more significant amount toward a down payment.
Private Mortgage Insurance
A sizeable down payment can be difficult for first-time homebuyers. According to the National Association of Realtors’ Confidence Index Survey, only ~28% of first-time home buyers put down at least 20%.
But 20% is important because it avoids private mortgage insurance (PMI). PMI is a fee you pay to protect the lender if you stop making mortgage payments, and it is generally added to your monthly cost. This fee helps safeguard lenders against homeowners who default on their loans.
The good news is you can have PMI removed after your home reaches 20% in equity by either requesting its cancellation or refinancing the loan amount. The specific steps vary depending on the type of insurance you hold.
In addition to PMI, you will pay a higher interest rate if you put less than 20% down. And the more money you borrow, the higher your monthly payment will be. With a smaller amount down, you may find it tough on your budget if rates rise (which they seem to do almost every year).
First-Time Homebuyers
However, first-time homebuyers may find several benefits to putting less than 20% down. First, you may be eligible for a first-time homebuyer tax credit. This tax credit could reduce the amount of taxes you owe or increase your cash back at tax time.
Another benefit is that some mortgage lenders grant lower interest rates with smaller down payments if the borrower has enough income/assets to cover their monthly obligations. Some lenders will also accept borrowers with student loan debt (up to 100% of their annual income) if they have strong enough savings and employment history.
If you can’t qualify for a conventional mortgage, VA loan, or USDA loan, programs such as FHA loans may require only 3% down!
Conclusion
Buying a house is a big responsibility, and it’s crucial to ensure you can afford the monthly payments before buying. If you don’t have an adequate amount saved, you may be tempted to stretch your budget to buy a house that is too expensive for your situation. And buying it could leave you financially vulnerable.
Instead of taking on more debt than necessary for your first home purchase, try saving aggressively for a period of time to see how feasible it is based on your household budget.
Mortgage rates fluctuate, so there is a chance you can eventually refinance at a lower interest rate. This would, in turn, reduce your mortgage payment. Of course, a rate drop is not guaranteed, and rates could remain higher for the life of your mortgage loan.
Talk to a fee-only financial advisor to help you determine the appropriate down payment based on your various financial goals.
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