Debunking the Myth That You Need 20% Down to Buy a Home

We all know conventional financial wisdom tells us we should put 20% down on a home, but I’ve always found it difficult to grasp hold of that theory especially now.

I moved to DC in 20003 when the real estate boom was in full swing. Houses were being bought and sold within a matter of days and weeks and realizing a of 25-40% ROI. It was amazing because I often wondered who are these people that bid over the asking price and paid 20% down? Let’s use Cameron Station as an example.

Cameron Station.

Cameron Station located in Alexandria, VA, noted as “the handsomest town” has to be one of my favorite places to live. Its a new planned community boasting a members clubhouse with a fitness club, swimming pool, guest services and main street retailers include flower shop, coffee shop and a deli/market. Its picturesque surroundings make it a delight especially with the fountain in the midst of the lake along the dog run. *swoon*

Of course I’d just wanted to rent there with no intentions of buying into the community because I didn’t see the logic in putting down $160,000 on a $800,000 town home, and I should add with no backyard. I’ve questioned that line of thinking since getting interested in real estate back then. Why? Because the bubble had to pop some day. Its the type of logic that most didn’t think twice about especially when 2005 rolled around and the market started to stagnate and buyers weren’t purchasing houses at 2004 highs. Still people kept funneling their life savings into these houses and where are they now? Most can’t even refinance because market conditions wiped out the equity and all they have is whatever a buyer chooses to pay for the home right now, putting the seller in a difficult situation.

From the Washington Post:

Lynn Edmonds and his wife, Sebnem, could barely wait to sign on the dotted line back in May when they committed themselves to pay $796,000 for a three-floor townhouse under construction in Alexandria’s Cameron Station.

But since May, the sales prices for the development have fallen — and units like the one the Edmonds bought are now being sold for $699,900. The Edmonds are facing the prospect of a $100,000 loss in value before they even walk through the front door.

Sad, but true. I wonder where that family is now and I’m actually quite curious as to their financial situation after buying that house. I am nosy in that way LOL!

So who does putting 20% down benefit? Where did it all start?

A Little History

From Dan Green @ The Mortgage Reports:

In 1956, when a bank stopped receiving interest payments on a mortgage, it took two important steps:

1. It took the home under possession via foreclosure
2. It did everything in its power to sell the home quickly

Remember, banks don’t like to hold real estate because they are not in the Real Estate business. Banks are in the “Making Money on Deposits” business.

To sell the home quickly, banks often sold homes at a discount to their “true” value. Not coincidentally, that have-to-sell-the-home-quickly discount hovered at 20 percent.

Steep, 20% discounts proved a terrific way for banks to rid their balance sheets of non-performing assets (i.e. homes owned by the bank on which no mortgage interest was being paid).

This is why The 20% Downpayment Myth ever existed at all.

Only, it wasn’t a myth up until 1956, it was the rule. A bank simply wouldn’t lend to a homeowner unless there was an up-front, 20 percent deposit on the home’s value. The 20 percent downpayment was really the bank’s insurance policy in case the homeowner defaulted.

In this sense, the bank was protected in the event of default whereas the homeowner stood to lose not only the house, but also the 20 percent.

This affair was truly one-sided in favor of the bank.

Over time, though, banks recognized that not all homeowners could afford 20 percent downpayments. Especially as home values began to increase. Banks also recognized how profitable mortgage lending could be.

PMI was born.

The PMI industry does exactly what its name implies — it provides insurance policies to issuers of mortgage credit. Using PMI, a bank could accept a less-than-20% downpayment, while buying an offsetting insurance policy in the event of default.

PMI benefited the banks in two way:

1. More money could be lent, increasing profits
2. The homeowner (and not the bank) paid for the bank’s insurance policy

Using PMI, a homeowner could make a 15 percent downpayment and buy an insurance policy for the remaining 5 percent down. This way, if the homeowner defaults, the bank can still drop the price 20% and walk away relatively unharmed — 15% comes from the (former) homeowner, 5% from the insurance.

Read more here, Dan really breaks it down giving us a good background on the myth of the 20% down payment.

Equity

In 2003, equity was a good thing! There were talks of buying homes with equity which made the deal sweeter. Buyers would then use the equity to leverage purchases of even more investment property which garnered them more equity with each purchase. And, rightfully so, prices during 2003 skyrocketed to astronomical levels here in DC.

Now? Not so much. Many homes are upside down with homeowners owing more than they paid for it, so the market is in the process of correcting itself if not on its way down to a recession. As such many people are beginning to realize that equity is only truly valuable when realized as cold hard cash.

Buyer Psychology Determines Realization of Equity

I don’t believe in “equity”, not until its realized money in my hand after a sale. Its “ghost money” and banks trick you into getting into more debt based on the equity on your house. Equity is the cash value of your home above what you paid for it. And another myth attached to the 20% down payment myth is that when you do put 20% down you automatically walk in with 20% equity that you may be able to borrow against in an emergency. Well, consider the family from Cameron station, if they had put 20% down, how much would that matter now? Their property value dropped significantly lower than what equity a 20% down payment would have afforded them.

So until I sell my home, the equity that resides here doesn’t exist. Why? Money talks BS walks, cash is king.

Recent Subprime Mess Means Less Equity for Most

Need I say more? Have you checked your house value in the last 6 months to a year? With short sales abounding and foreclosures rampant, these affect the prices of homes in the neighborhood. So be careful to think that if you’re paying 20% down that you will somehow have a built in nest egg due to your equity. If your home doesn’t appraise to the needed value then you are stuck until you sell your home. And, that is if you sell at a price needed to get back the 20% you put down.

My personal opinion? I think its foolish to put 20% down on a home. I would rather take my chances with the stock market. I know, feel free to set me straight in the comments

20% could be invested wisely in the stock market instead of sitting in your house

I have been screaming this from the rooftops since my mom bought her first house in 1999. No way would I lock up 20% in a house hoping that I will somehow benefit from it when this was all structured to benefit the bank in the first place. Think about it, if you wanted that 20%, you’ll have to PAY to get it if you aren’t selling your house. How is that a profit?

Also consider that buying a home may not be such a wise investment decision, check out these articles:

• The Cost of Buying a Home Over 30 Years
• 3 Reasons Not to Buy a Home
• Sometimes renting is just fine
• Why we rent
• Skip the 20% Down Payment

So do your research behind what may seem to be conventional financial wisdom. Your money should be working for you 100%. Not the bank. Paying 20% pays for the bank’s risk they take on by loaning you the money.

I’m interested to hear your thoughts on this as I know that it is a rather controversial topic. Many are invested in the myth that they need to put 20% down to buy a home, but my reply to that is….is buying a home profitable in the long run when you calculate all expenses involved (not just the purchase and sale price!)?

Do you still think that 20% is needed to buy a home?

How do you think 20% benefits the homeowner?

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