The 20% Down Payment Myth

You have heard it, I know you have, heck it seems that most everybody thinks that they either need a 20% down payment to be able to buy a home or that they have to put 20% down to get “the best deal,” or that putting anything less that 20% down is risky. Once again what is widely called a “rule of thumb” ends up protecting everyone except YOU!

Let’s first discuss the origin of the 20% down payment. It comes from the ugly side of real estate, when something bad happens to good people and they end up in a foreclosure situation. A homeowner stops making their payments for 90 days or more and the bank begins the legal process of getting their collateral (the house) back from the people that aren’t living up to the contract they signed to make the payments on the loan for the house.

The problem here is that Banks aren’t in the real estate business they are in the getting deposits and lending it out business. When a bank has to foreclose on a home they are no longer in the deposit and lending business they are in the real estate business. A bank decides to take back a house when they realize that they haven’t been getting their interest payments on the loan for at least 3 months.

Put yourself in the banks shoes. They have done a $150,000 mortgage at 6% and they haven’t gotten their $899.33 a month for three months. See when this process starts the bank knows that they could go 6 to 12 months or more without payments, many times the people in the house are mad at the bank and they think that things like kitchen cabinets, sinks, toilets, etc are theirs and they tear them out of the house. They stop taking care of the house and sometimes they even trash the house.

So the bank knows that they won’t get payments for 3 to 12 months or more, the house will probably need a good amount of repairs, they have legal fees, they have to pay the real estate commission to resell the home and who pays retail for a foreclosure. Remember that banks are in the business to make money and not lose money. So they figured that if a home buyer put 20% down that would generally give them enough “wiggle room” to be able to recoup some of if not all of their costs and get the property sold quickly. As we all know if you want to sell a property quickly we need to LOWER the price.

So, that is what the banks decided to do. They calculated that to sell a foreclosure quickly they would need to reduce the price by 20% and buyers will buy that property quickly and they can get their loan proceeds back and lend them out again. That’s how they make their money.

So if the homeowner made a 20% down payment and the bank sold the home at a 20% discount, then the homeowner had everything to lose and the bank had very little risk. Sounds like a great deal doesn’t it? A great deal for the bank. Funny how the “rules of thumb” we live by are designed to protect everyone but us. This “rule of thumb” was designed to protect the bank from losing money.

With all of that the 20% down payment myth was born. The difference between then and now is that 20% down was the rule, there weren’t Private Mortgage Insurance companies and lenders weren’t doing piggy back second mortgages to make up the difference over 80% loan to value.

Over time, as home prices rose banks began to realize that most people that wanted to buy a home couldn’t come up with a 20% down payment and the housing market slowed greatly. This created a new industry- the Private Mortgage Insurance (PMI) Industry. With PMI the bank agrees to lend more than 80% of the value of the home, but they require the buyer to take out an insurance policy to protect the lender if the buyer doesn’t pay back the loan.

The premise of PMI is directly linked to the idea that a bank doesn’t want to be in the real estate business and if they find themselves with a home they will discount it 20% to sell it quickly. Think about it this way if you put 5%, 10% or even 15% down you still need PMI, the premiums you are paying get lower the more you put down, but you are still paying for an insurance policy that only benefits the bank. The bank still has very little risk in fact most of the risk falls on you.

As the use of PMI expanded, homeownership levels jumped up tremendously. Over time banks saw the money the PMI companies were making so they reassessed their risk involved in a real estate transaction and they began offering their own alternatives to compete with PMI, thus the birth of Home Equity Lines of Credit (HELOC) and Home Equity Loans (HELOAN) to make up some of if not all of the traditional 20% down payment.

Banks realized that revenue stream was significant and since they were dealing with that high risk 20% they could get away with charging higher interest rates. More risk needs to have more reward or nobody will take that risk. Thanks to PMI, HELOC and HELOAN we can now purchase homes with little to no money down. Banks love these second mortgage products because they have a built in profit margin. They are generally based on Prime rate plus a margin otherwise known as a margin of profit.

So in summary the 20% myth began back in the 1950’s or so and has lived until today and will probably continue to live because we as Americans just haven’t realized that rules of thumb normally protect everyone but us.

Don’t fall into the trap of putting 20% down. Many of our clients don’t put any money down on a home. Not because they can’t, but instead because it is a better financial move for them not to put money down. They realize that home equity fails the three tests of a prudent investment, liquidity, safety and rate of return so they keep that money separated into safer, more liquid side accounts that can earn at or above their net cost to borrow. Many times this will create hundreds of thousand if not millions of additional dollars in their investments. Our clients also realize that when they put any money down they are transferring the risk from the bank to themselves. So don’t put money down, instead find conservative, liquid investments that earn at or above your net cost to borrow. It’s easier than you think.

Creating Wealth Through Smart Mortgage Planning