If you’re thinking about buying a house, you’ve certainly got a ton of things to consider. But while you’re busy poring over floor plans, school districts and paint colors, you also need to make sure that you’re buying that house the right way, with the right mortgage.
In general, borrowing money is a bad plan, because debt is equivalent to financial slavery. There is one notable exception though: When we buy houses, home mortgages can be valuable tools. Mortgages help us to get into permanent homes sooner in life (instead of having to save hundreds of thousands of dollars in cash), and are structured in such a way that they don’t come with many of the dangers of regular consumer debt. Mortgages are the only debt that’s okay.
That doesn’t mean, however, that all mortgages are okay. Mortgages have a lot of benefits, but there’s also plenty of ways for us to screw them up. They can be a safe financial strategy, but if we’re foolish with mortgages, they can ruin us like any other kind of debt. There are several keys to making sure that you use mortgages the right way. Today, we’re going to focus on your down payment.
There was a time, five to ten years ago, when all that you needed to get a mortgage was to walk into a bank and tell them that you had a job and wanted to buy a house. Lenders were making so much money on mortgages that they were quick to hand them out to almost anyone who wanted one. It didn’t matter if you had any money saved, or how good your financial track record was.
Unfortunately, that freewheeling mortgage philosophy ended up backfiring on the banks and many of the unqualified customers who took out mortgages that they couldn’t really afford. It got so bad, in fact, that the mortgage crises was a major cause of the economic recession that we’ve been fighting our way out of since 2008.
One of the biggest mistakes that the banks made was to give people 100 percent of the money that they needed to buy a house. Traditionally, banks have wanted to see that you’ve saved some money on your own, and wanted you to put up a little bit of your money in addition to the money they were loaning you. That money that you contribute is called a down payment, and for a while in the early 2000s, the banks didn’t require it at all. But when home values fell a little bit, people who made no down payments had no equity in their homes, and they ended up underwater. One job loss or medical crisis, and those same people ended up bankrupt, foreclosed on and out on the street.
This all could have been avoided if the banks had held their traditional line on down payments, and today, most mortgage lenders have returned to normalcy on this policy. On a personal residence, a bank may require you to bring a 5 percent or 10 percent down payment. But just because that’s enough for the bank doesn’t mean it’s enough for you. If you’re thinking about buying a house soon, we strongly advise you save enough money to pay for 20 percent of the home on your own.
Why 20 percent? There are several reasons. First, saving enough money for a 20 percent down payment will reduce the amount of your overall mortgage, thereby reducing your monthly payments and the amount of money that you pay in interest each month. Over the lifetime of the mortgage (15-30 years), these interest savings can be substantial (thousands or tens of thousands of dollars). And with a lower monthly mortgage payment, you have more money in your budget for other things, like investing, giving or having some fun.
Secondly, a 20 percent down payment gives you automatic equity in the home, and puts you in a safe position in the fluctuating housing market. If you only have 5 percent equity in your home, and then housing prices fall, you could very easily end up underwater — owing more on your mortgage than your house is worth. In some areas, housing prices have fallen by a lot more than 10 percent since 2008. And while there’s no guarantee that some economic catastrophe won’t lead to further home depreciation, having 20 percent equity in your house gives you much more protection than the bank minimums do. With that much equity and a long-term plan to stay in that house, you can rest easy even as housing prices fluctuate.
Finally, putting 20 percent down saves you from having to pay Private Mortgage Insurance, or PMI. Basically, banks know that people who have little equity in their homes are at a greater risk of defaulting on their mortgages. Since the banks don’t want to lose the money they loan, they require low-equity borrowers to pay for third-party insurance that will reimburse the banks in the case of default. That insurance, or PMI, is added to your monthly bill, and can amount to several hundred dollars each month in additional expenses. For most lenders, 20 percent equity is the magic breaking point where they don’t require PMI. So if you bring a full 20% down payment, you can avoid having to pay this fee, which will cost you thousands of dollars over time.
There’s a lot more to think about when picking the right mortgage. Next time, we’ll look at the difference between fixed rate and adjustable rate mortgages, and help you decide which one is best.
Photo by Diana Parkhouse. Used under Creative Commons License.