Save For A Down Payment or Buy Now? (Part 1 of 2)

An email asked a question I should have thought to answer a long time ago, and the answer may surprise a lot of folks. I've been vaguely aware of this for a couple of years, but I was amazed how strongly the numbers solidified my views!

My wife and I aren't ready to buy a property yet, but we are trying to plan how much to save for our down payment. You've mentioned that there's a spectrum from nothing down to 20+% down broken down by 5% increments, but how do you choose where to be on that spectrum? I can see that there are tradeoffs between the amount you have to save, the cost of your mortgage and the like, but I don't have a good way of thinking about those tradeoffs. And, since we're in the DELETED area, 20% down could easily get into the six figures, so it can be quite intimidating.

Given the way leverage works in even a slightly appreciating market, it is generally to your advantage to buy as soon as 1) You are sufficiently stable in your employment and expect that you're going to be in the area at least another three to five years, 2) You have enough of a reserve that the first minor bump in the road will not lead to disaster, and 3) You make enough to afford the payments. However, what usually happens is that people get a raise, a promotion, or a new job, or more often, they get married or have a baby and that is what sets their thinking on the road to buying a home.

(Note: When I originally wrote this, loans available were different than they are now. But the situation will go back to that eventually, and there are ways to make a minimal down payment work, even today, and the basic ideas I'm presenting are, if anything, more valid than when I originally wrote this)

Let's consider a $500,000 property and an 80% first trust deed with an appropriate piggyback 30 due in 15 second if needed, since that is generally returning more favorable rates than a Home Equity Line of Credit right now. When I originally wrote this, I had 5.875 for about 9/10 of a point plus closing costs, or about $7100 total cost. But there are potential adjusters - and relevant to this situation, having subordinate financing for 100% CLTV added one full discount point ($4000 in this case) to the first mortgage, or you can drop down to 6.25 for the same cost. 95% financing only adds 1/4 of a point in the same situation, or you can get a 6% even for the same cost. At or below 90% CLTV, there was no add to the first mortgage. If we're at 80% with a $100,000 (20%) down payment, the 5.875 first is all there is. Taking dead average credit scores (720) with this same lender, the closing costs are $500 (flat) when you do the second concurrently. 85% CLTV would be an 8% second on $25,000 for a down payment of $75,000 (15%) plus closing costs. 90% CLTV would be $50,000 down payment (10%) and leave you with a $50,000 second at 7.375%, benefiting from a bump down in rate for hitting a certain dollar value. 95% CLTV requires a $25,000 down payment and leaves you with a $75,000 second at 7.75%. 100% CLTV (no down payment) leaves you with a $100,000 second at 8%. It would be 8.25, but you've hit another economy of scale break point.

Here's a table:

So you see that having a down payment is a very good thing. Now this is for a fairly ideal situation. If you were in a stated income situation (when we had stated income loans, which nobody does any longer), the rates were slightly higher and step somewhat more steeply. If your credit is significantly below average, the rates start higher and step up more steeply still. It gets rough if both apply.

However, this doesn't take place in a vacuum. Let's say you can save $10,000 per year, and earn 10% tax free on what you save. But while you do, housing prices are still going up in the aggregate (at least when the economy is healthy, and if the economy doesn't get healthy soon we'll have worse things to worry about then whether to buy real estate). Let's assume 5% per year on average. We will also assume that you can get a 6% loan for the first and 8% for the second whenever you buy, and taxes at 1.2% of value per year, here's the projected situation:

Where payments is the total of mortgage and monthly tax payment pro-rated when you buy. Examining that column, we see that this is an argument against waiting. In fact, assuming a 3% (compounded) raise per year, the property is only 4% more affordable in year 10 with a $167,000 down payment! This neglects rises in rents and other costs of living!

I should mention that smooth raises are not the way any market works over a 10 or 20 year period. Up, down, flat, crash, skyrocket, all happen due to unforeseeable factors, as well as ones you'd have to be a politician to not see. The basic ideas remain sound as a general principle, although the actions of politicians can certainly influence them - upwards or downwards. But in general, over the long term, markets have population increases and increased demands on the land available. Real estate prices increase in the long term, whatever may happen in any individual year (or few years). leverage makes the effects of that increase have spectacular financial effects.

At this update, the only 100% financing that is generally available is if you are eligible for a VA loan, but the principles remain the same. Once you have enough to make a down payment acceptable to lenders, the numbers are very strongly in favor of buying instead of waiting for a larger down payment. FHA loans require only 3.5% down, and are available to basically everyone who hasn't defrauded the federal government.

Original here

(Here is Part 2 of Save For A Down Payment or Buy Now?, which tells one way to increase affordability more and faster)