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:
- It took the home under possession via foreclosure
- 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:
- More money could be lent, increasing profits
- 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?
About the Author: Girls Just Wanna Have Funds is for the woman that wants to take charge of her personal finances. We value budgeting, investing, frugality and remain mindful of our spending habits. Move over and make way for women who are in control of their financial destinies and not afraid to say it. We're armed with a positive net worth and not afraid to flaunt it while breaking financial ceilings one stiletto at a time!
Fabulously Broke (8 comments.) | Mar 27, 2008 | Reply
I’m definitely of the mindset that renting would be a real good option for me if the prices of homes were ridiculous
I don’t NEED to have a backyard or my own “home” or do to the repairs to it, or fix it the way I want.. for me, my home is really a subjective emotional sort of thing… it’s what I make of it.
savvy (9 comments.) | Mar 27, 2008 | Reply
I think that if you’re trying to buy a house for an ‘investment’ or not planning to stay in it for very long, then putting 20% probably isn’t best. You’d do better keeping your funds somewhat liquid. I won’t even get into the subprime mess because I think it’s a matter of people’s stupidity/ignorance/greed catching up to them.
For those who are buying a home (vs just a house) that they intend to stay in, 20% down is a good idea provided you have a solid e-fund in place. You will lock-in a low rate mortgage and your monthly payments will be minimized. Also, you will avoid PMI (IMHO, throwing away money despite the fact that it recently became tax-deductible).
In the end, I think it all boils to down WHY you are buying. We didn’t buy our house with the intent of making it profitable. We bought it because we wanted to settle down and have a HOME. We don’t intend to move again, therefore we’re paying extra toward the mortgage (which is also highly debated) to get it paid off more quickly.
c2a (7 comments.) | Mar 27, 2008 | Reply
A home is a place to live and it seems people forgot that over the last few years. Your children may profit when you die, either by selling or having a place to live, or maybe when you are old you can get a reverse mortgage and live off the house.
I think little to 0 down can work for many people, especially if the property cost is very low in relation to income. But then that might mean they are prevented from taking a work hiatus or switching careers. I personally never want to be locked into needing a certain income so 0 down couldn’t work for my life strategy.
I want as much down as possible but no less than 20%, because I’ve always been self-employed and try to keep expenses low with my fluctuating income. Low price homes in L.A. are still riding in the 600ks, 20% down would leave a mtg payment of $2800 and 0 down would be around $3600, if I got the same interest rate on the 2nd. 2nd mortgages tend to be at a higher percentage and shorter term and could put it at more than $4100 per month. Then add property tax on top and you’re looking at near $5000 a month.
If I bought a house I loved and it lost equity or value I wouldn’t feel foolish. I would hope my property tax would decrease. I would be upset about the folks who figured out walking away was a good financial decision because they put nothing down and lost equity and were upsside down. That’s how neigborhoods fall apart. That’s also why I choose established neighborhoods, even if the homes lose equity the neighborhood is stable.
Meg (13 comments.) | Mar 27, 2008 | Reply
Putting 20% down is not necessary, especially for first time homebuyers. Mortgage lenders have many different products (loans) available for those who don’t have the full 20% downpayment - of course you’ll pay a premium for those, usually 1%-2% higher on your rate. You’ll also pay PMI, which can be several hundred extra dollars a month.
So if you have the 20%, it’s a good idea to use it to put down. Even 10% will get you lower rates. These days few lenders will lend to you with nothing down, even if you have great credit and a huge net worth.
Putting 20% (or any amount) down doesn’t just benefit the bank, though. It benefits YOU. Not only are you lowering your monthly payments - and the total amount you’ll pay on interest over the life of the loan - but it enables you to be able to sell and move quickly if you decide you want/need to. If you take out a 100% loan and then want to suddenly move in 2 years to accept a new job, your home probably hasn’t appreciated enough for you to sell (remember the selling costs will include a 6% realtor commission). But if you have equity in your home, you don’t have to worry that you might sell and not have enough to pay the bank back, even if you have to do so soon after closing.
In any event, home ownership is designed to be long term in nature. There are few easier ways to build wealth than buying real estate and holding, even and especially if you have a mortgage. Let’s review - you buy a $100,000 home and put $10,000 (10%) down. You owe $90,000. Your home value goes up 4% - $4000 in the first year (this is the average over time in most areas). You also pay down the mortgage a teeny bit - let’s say by $600 that year. So now you owe $89,400 on a $104,000 house. Your equity grew from $10,000 to $14,600 in one year - a 46% gain. Try doing THAT in the stock market.
Ginger | Mar 27, 2008 | Reply
Meg, thanks for the input but honestly during these times I’d like to see that in practice before I committ to that line of thinking ever again. You have to include EVERY PENNY that you put into the house which includes taxes, insurance, maintenance etc etc.
Taxes in DC metro are RIDAMNDICULOUS and would certainly bite into that profit. Furthermore, no house here in DC unless it is a 6-10 plot of land will go for 100k. Nothing here that is livable is worth 100k so I’d like to see that in practice which for this area means starting out at 350k depending on the area. Remember you must add everything you spend on that house in order to determine your REAL profit, not just want HGTV tells you your profit will be which is never the bottom line number.
Ive yet to meet a family that has found the house they will stay in for 30-40 years. I dont see where tying up 40k in the name of saying $300 a month makes sense? I would rather pay cheaper rent and invest that 40k. Given the fickleness of the market my 40k is best elsewhere. Maybe not entirely in the stock market but certainly not left to the whims of buyer psychology and rough economic times.
Al (1 comments.) | Jul 27, 2008 | Reply
I would argue that a 20% down payment helps to protect both the lender and the home buyer. Going with a small down payment exposes the home buyer to considerable risk. See my post at http://www.observationsandnotes.blogspot.com/ .
Al’s last blog post..Subprime Mess