What Is A Down Payment? Skin In The Game For Large Ticket Items

As a multi-property homeowner since 2003, coming up with a down payment for a house is a must.

A down payment is a percentage of the house's value in cash you pay the seller. The down payment can be 0% or up to 100% if you are an all-cash buyer like I did with a house I purchased in 2019.

The money owed after the down payment is your mortgage. The mortgage is almost always borrowed from a bank in terms of an adjustable rate mortgage or a 15-year or 30-year fixed rate mortgage.

Given mortgage interest rates are at record lows, demand for real estate has been strong. Affordability has increased and money is flowing away from volatile stocks towards real estate.

The Importance Of The Down Payment

When you buy a house, you as the buyer need to come up with a down payment to show “skin in the game.” The larger the down payment, the more skin in the game and the more comfortable a bank is lending you the remaining balance.

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Not only do people put down payments down for a house or a commercial real estate investment, down payments are also common when buying a car, a boat, and any other large ticket item.

Thankfully, credit is widely available and interest rates are still fairly low. If that's not the case for you, a larger down payment is required for purchasing such items.

The Minimum Down Payment On A House

The minimum down payment on a house is usually 3.5% if you are a first-time homebuyer taking out an FHA loan.

Here are the various types of loans you can get when buying a home with a corresponding down payment amount.

  • Conventional Loans. The minimum down payment requirement is 5% on owner-occupied properties for most loan types. However, some programs require only 3%. An example is the FNMA HomeReady loan, though it’s designed specifically for lower-income households.
  • Jumbo Loans. These are larger loan amounts for higher value properties, that can run into millions of dollars. They are not sold to Fannie and Freddie Mae. The minimum down payment is 10%, but is usually 20%.
  • Federal Housing Administration (FHA) Loans. The standard down payment requirement is 3.5%. But that will rise to 10% if your credit score is below 580.
  • Veteran Association (VA) loans. VA loans allow for a 0% down payment, meaning they are willing to finance 100% of the home thanks to a veteran's service in the military. We need to do more for our vets and this is a great step.
  • USDA loans. USDA loans also allow for a 0% down payment. USDA home loans are designed to be used specifically in rural areas of the country. However, the loan program is quite generous in its definition of rural. It takes in a surprising number of counties throughout the US that many would consider as suburban. Approximately 97% of counties throughout the US are considered eligible for USDA loans.
  • Rental property and vacation loans. Given these type of properties are not core necessity housing, the minimum down payment for these loans is usually 25% – 30%. The banks want more skin in the game because they believe you are more dependent on the rental property to pay the mortgage.

Sources For Down Payment Funds

Your down payment generally needs to come from you before a bank will lend you the rest of the money needed to buy the house. During the underwriting process, the lender will check the sources of your funds by going through 2-3 months worth of bank statements and other financial statements.

The source for your down payment can come from cash in your savings or checking account, your investment brokerage account, withdrawal from your retirement accounts, and a financial gift from a family member.

When you hear about The Bank Of Mom & Dad buying their child a house, a down payment gift is usually the main example of what's happening.

Typically, the entire down payment can come from a gift that is equal to at least 20% of the purchase price. If it’s less, you’ll generally be required to have at least 5% of the purchase price coming out of your own resources.

FHA regulations are more relaxed. They don’t have an own funds requirement, so the entire down payment can come from a gift from a family member. But there are many down payment assistance programs, usually offered by state, county, and municipal governments, that will provide a grant or forgivable loan for the down payment in connection with an FHA mortgage.

And of course, since VA and USDA loans have no down payment requirements at all, the source of funds is not an issue.

The Appropriate Down Payment To Put Down

You need to put down at least the minimum down payment to qualify for a mortgage to buy the entire property.

A smaller down payment is good because:

  • Leaves more liquidity
  • Provides more leverage on the upside
  • Allows you to buy more house
  • Doesn't disrupt other investments that would require liquidation
  • Allows you to earn income and gains on money not in a down payment
  • Allows you to take advantage of low mortgage rates

A larger down payment is good because:

  • Usually results in a lower interest rate because the banks see you have more skin in the game
  • Better pricing terms with the seller as the seller feels more comfortable and knows that you are serious
  • A smaller mortgage, so smaller mortgage payments and less interest payments over time
  • Avoid private mortgage insurance (PMI). PMI is required on both conventional and Jumbo mortgage loans anytime you make a down payment of less than 20%. 
  • A larger down payment will also give you a bigger equity cushion in the event of a downturn
  • Potentially more peace of mind during a downturn due to less leverage
  • Easier to refinance your mortgage when mortgage rates fall further

No Money Down Purchase

In general, I don't recommend buying a home with no money down. If you want to go with a VA or USDA loan loan, that's fine. But for a conventional or jumbo loan, I think everyone should put down at least 20% to avoid PMI. Your ultimate goal is to own your home outright i.e. without a mortgage.

FHA mortgages allows for a standard 3.5% down payment, but you can often get down payment assistance from a local government in the form of either a grant or a forgivable second loan.

But do you really want to borrow money to borrow money? I don't. Leverage is great on the way up, but deadly on the way down. If you only have a 5% down payment and the market goes down 10%, you now have negative equity.

Instead of buying a property with no money down, I recommend buying a property with an all-cash offer to get the lowest price possible. You can actually buy a property with all cash without having all cash using the no financing contingency strategy.

How To Accumulate And Invest Your Down Payment

Having a solid down payment is important if you want to buy a house in a competitive situation.

The main variables in your down payment are: time, return, risk, existing cash, and cash flow.

Here are some assumptions to think about when investing your down payment:

  1. The closer you are to buying a house the less risk you should take.
  2. The lower your risk tolerance, the lower risk you should take.
  3. The better your investing acumen, the more risk you are able to take.
  4. The higher your existing cash balance (down payment or full payment), the more risk you can take.
  5. The higher your cash flow, the more risk you can take.
  6. The higher the mortgage interest rate, the bigger the down payment you should make.
  7. The higher you expect mortgage rates to go, the pickier you should be.
  8. The more bullish you are about your financial future, the more leverage you may take.
  9. Investments should be made in investments that can become liquid by the time you want to purchase.

A home is a wonderful asset class because it provides shelter and it can potentially go up in value. Just make sure you come up with a large enough down payment so you can comfortably afford the property over the long run.

Once you've outlived your property, you should refinance it if rates are attractive and rent it out. Do this several times in your life and you will build a nice retirement income stream.

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