Don't Put 20 Percent Down When Buying A Home!
Don't put 20% down on a home in 2021!
For those homebuyers who have significant cash reserves, the questions that arise when considering financing options are a serious matter. Should you put 5% down? 10% down? 20% down? What exactly is the best down payment to make when you have the ability to put some cash into your home?
The more money that you bring as a downpayment, the lower your monthly mortgage payment. On the other hand, it also means that you have more cash tied up in your home than the bank requires. So what do you do?
Today, we're going to look at three different scenarios that a cash-strong buyer could consider, and I promise you that you will take away a different perspective once you see the analysis I provide.
Even if you don't change your mind, you will certainly have something to chew on before you decide what your downpayment will be.
Must-See Tips For Homebuyers
Thought-Provoking Exercise To Grow Your Money
I want to preface the analysis with a note that this is just a daily blog post. Some of what I will reference as fact won't show the supporting documentation one would see in a scholarly work, but you can find said strong support if you check out my recent videos on the Joe Manausa Real Estate YouTube Channel where I discuss (at length) the many points that I just brush over here.
Take this post as more of a thought-provoker rather than specific guidance for when you buy your home. This conversation should be continued at length with your trusted real estate and/or financial advisor.
Different Times Call For Different Answers
We are facing unprecedented times in the US housing markets. Home values are skyrocketing as builders have not been producing enough homes to satisfy the growing population. With the cost of construction moving higher faster and expected to accelerate, one can only imagine how home affordability is going to suffer over the next decade or two. (see this video on home affordability).
Additionally, the 40-year trend of declining mortgage interest rates is about to turn around and perhaps head higher for the next 40 years or so. This generational change in interest rates and the soaring cost of construction will mean a very different housing market will emerge in the coming years, but it also provides an interesting opportunity for those who are paying attention.
I ask you to keep an open mind, as I'm going to show you why you should not put 20% down when you buy your next home.
Your Agent Matters!
74% of homebuyers work with the first agent they speak to, so they typically don't understand that it is in their best interest to first interview a qualified buyer's agent before they commence with the rest of the home search and home buying process. But they learn.
They learn when they ...
- lose out on the perfect house
- pay excess third-party fees during the transaction
- over-spend for a home that they could have bought at a lower price
- the home is not the best fit for what they need
So join the 26% of homebuyers who are smart enough to put themselves first. Here's how to do it.
How Much Cash Should You Put Down?
As far as I am concerned, there really are three ways you should go about determining your down payment. If you are wealthy and are debt-adverse, just pay cash for your next home. If you are cash-strapped, then look to one of the no-money-down loans you can get from USDA or VA, or at least a low-money-down loan through the FHA or a conventional product.
But if you are in the "rest of us" category and you happen to also be fortunate enough to have some cash reserves, then I want to show you three realistic scenarios for you to consider. Again, I might brush over some of my assumptions as if I have not given them much attention (like how homes will appreciate over the next 20 years), but you will find my full analysis and discussion of these critical issues if you watch the videos on our channel.
Why Now Is The Time
Two of the three scenarios that you are about to review will make a lot of sense to you, but the third might just blow you away when you first take it in. Just remember, it's only a thought-provoking exercise, though I am completely in the corner of the "crazy" option.
We are at an interesting time in history. Mortgage interest rates are near an all-time low, but history tells us that this will not last forever.
The graph above plots 50+ years of mortgage interest rates, and we can see that rates have been generally falling since the early 1980s. Today's rate is less than 1/2 of the fifty-year average, and I propose that these are "borrowing times." There is a time to take on debt, and there is a time to avoid it. Right now, they're lending money at 3% interest, can you invest that money for a return that exceeds 3%? I would argue that this is an easy "yes."
The real estate market is going to be moving away from homeownership and towards a landlord/tenant market when rates begin to rise. Homes today are more affordable than they were in 24 of the past 30 years, but we're about to see this trend turn upside-down. Why? Because home values are exploding, and with supply at historic lows, there is no immediate end in sight.
And if you are of the camp that believes that home prices are going to come down, you should (watch this) and know that the average home price in the US only declined in ten years since the great depression of the 1930s! So investing in leveraged residential real estate right now makes sense because interest rates are at historic lows and home values are moving higher (supply is low, demand is high) and production on the supply-side is nearly halted due to rising building and land costs.
So here's my crazy thought for those buyers who have some extra cash. What if instead of putting 20% down on your next home, instead, you bought two homes? One would be for your personal residence, and one would be used as a rental property. You would lease it out to a tenant so that you could enjoy the high rates of real estate inflation that we'll be seeing over the next twenty years.
Three Scenarios: How To Finance Your Next Home
So what would the numbers look like? Well, I've prepared a table below that shows the investment required and the benefit received for each of the following scenarios:
- Buy a home - put 20% down
- Buy a home - put 5% down
- Buy two homes - put (5% down on your residence, 25% down on the investment)
Remember, this isn't for everybody, you need more cash to do the investment than you need for the personal residence due to the loan product requirements. But if you have the cash, pay close attention to the "crazy" route.
The following graphic shows three side-by-side tables, each depicting one of the three scenarios mentioned prior. Each table shows the equity you will have and the return on your investment. The numbers appear incredibly high, but all of this will be explained below.
The first thing you should note is that all three examples show incredible returns. One might even say "unbelievable," right? Well, let me show you why they are in fact likely to occur.
First of all, the equity in each scenario is the combination of the downpayment paid, the principal paid with each monthly payment, and the appreciation gained by owning a home during the highest appreciating market real estate has even encountered. Remember, the combination of low mortgage interest rates and rapidly rising home values will put cash in your pocket. But even so, why is the ROI so high?
It's all about leverage. A portion of the purchase price is your investment, but it is the total value of the property that is appreciating. By way of example, if you buy $100,000 worth of stock and it goes up 16%, you have made $16,000 (16%). But if you buy a $100,000 home and it goes up 16% (which is lower than this year's appreciation rate), you invest $8,000 ($5,000 downpayment and $3,000 in closing costs), your $16,000 gain is not 16%, it is (16,000 - 3,000)/8,000 = 163% ROI. That's ten times better than the stock ROI.
I know the leverage example was overly simplistic, but it explains why leveraging residential real estate can be very lucrative during certain housing market cycles. This is one of those cycles, and it is stronger than we have ever seen!
So looking back at the table, all three options look great right now. The first table shows a 20% downpayment, and it is a wonderful rate of return. But its ROI is the lowest of the three options.
The table on the right shows a 5% downpayment. It delivers the highest rate of return of the three, but the gain in equity is the lowest.
The table in the center is my "crazy" option, and it returns the most money of the three options. Why? Because you are using your money to leverage more real estate, and that real estate is going to explode in value over the next ten years. It really is that simple.
Why It's Not That Simple
OK, maybe it really is not that simple. When you buy stock, you click a few buttons and then you go about your life. You occasionally check in on it to ensure nothing bad is happening, but otherwise, it is not an active investment that requires you to really do anything.
Owning real estate is different. If you hire a property manager, you will have less work that you need to do, but it will still require far more of your time than would owning a stock investment. You'll need to ensure your manager is maintaining the property (after all, that's your equity), and you'll want to review the property financials each month.
I would argue that the ROI makes it worthwhile, but for some, that wouldn't be the case. It's a personal decision you need to make. I would strongly advise you to NOT jump into being a landlord, rather it would be prudent to first discuss the ins and outs of property ownership with your trusted real estate advisor.
Final Notes On The Data In The Table
For those that are still bewildered by the returns shown in the table included above, I used the following information:
- Appreciation Rates: 16% Year 1, 16% Year 2, and 5% annually thereafter. You can find my support for these HERE.
- Mortgage Interest Rates: I used 3.1% for the owner-occupied homes, and I added a full percent for the investment loan (4.1%). All loans were amortized over 30 years and required monthly payments.
- Equity Formula: downpayment + appreciation + principal paid
- ROI: (Equity - Downpayment - Closing Costs) / (Downpayment + Closing Costs)
The appreciation rates in the next few years will be mind-boggling, and that is why I prepared this article for our readers. If you would like to discuss your situation with us, we are here to help.
Remember, with money being so cheap at 3% today, you should consider keeping your cash so that you can invest it at a rate higher than you are paying to borrow for your home purchase.
It just does not make sense to put 20% into your home today if you are still at a point in life where you are trying to grow your wealth. Even if you choose something other than leveraged residential real estate as your investment vehicle, certainly you can outperform the 3% cost of money, right?
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