You Can Buy A House With 3% Down... But You Shouldn't

by: Evan Powers

Summary

Younger homebuyers, especially those with student loan debt, are increasingly turning to low-down-payment mortgages in order to purchase their first homes.

It can take anywhere between 3 and 6 years for a low-down-payment homeowner to break even on their purchase, which can significantly limit lifestyle and career flexibility.

Low down payments could also help contribute to real estate market volatility, which would be the most damaging for those homeowners with the least home equity.

Earlier this week, NerdWallet's Teddy Nykiel published an article with a very alluring headline: "Buy a home - even if you have student loans - with these 5 tips." What follows is a fairly innocuous discussion of a young married couple and their journey to homeownership despite one partner's lingering student loan debt. She wrote:

The Couches are part of a generation that's delaying major life decisions, like whether to buy a home, because of student loan debt. More than half of student loan borrowers say their debt affects their ability or decision to become a homeowner, according to a 2015 survey of 1,934 student loan borrowers by American Student Assistance, a Boston-based nonprofit. But becoming a homeowner is possible even if you have student loans.

Nykiel is generally right, and she's covering ground that I've covered before when it comes to the Millennial Generation. Just having student loans shouldn't (and doesn't) disqualify you from being a homeowner, and any decision to rent or buy a home should take into consideration the entirety of a family's financial situation, not just one loan balance.

That said, what concerns me about Nykiel's piece is one glossed-over line toward the end of her story about the Couches, one that I'd argue amounts to a buried lede.

A traditional down payment is 20% of the cost of the home, but there are other options for borrowers today... Despite Kristin's student loans, the Couches were able to buy their home with just 3% down through a local bank.

Immediately upon reading that line, alarm bells started going off in my financial planner brain. Sure, the Couches were able to buy a house without having anywhere near the traditional down payment, but that doesn't mean that doing so was necessarily a good idea (it brings to mind a scene from a certain Simpsons episode from years ago, a personal favorite).

Yes, it's a brave new world out there for borrowers, spurred in part by FHA-insured loans (and new programs from the big banks) that require lower down payments than have traditionally been required. As recently as 2010, more than half of first-time homebuyers made their purchases using FHA loans, essentially all of them eschewing the traditional advice to target a 20% down payment before buying a house.

Indeed, the wisdom of that 20% down payment advice has been questioned by some in recent years, despite the fact that most borrowers continue to heed it (according to LendingTree, the average down payment for a conventional 30-year mortgage currently sits at around 17.5%). And some of the arguments in favor of lower down payments do, in fact, have merit.

However, I'd argue that the scenarios in which a low down payment is a good idea are both overly specific and too few and far between. For the vast majority of borrowers - first-time homebuyers or not - it's still best to accumulate a large down payment before purchasing, particularly for young families (like the Couches) who already have debt on their balance sheets.

Here are a couple of reasons to just say no to 3% down payment mortgages.

You're immediately underwater

Part of the reason that the traditional down payment amount came to be 20% had less to do with pure capital protection ("skin in the game") and more to do with offsetting the often-sizable closing costs that come along with buying and selling a house. If you don't have enough equity in a house via your initial down payment, you could end up having to bring cash to closing when you sell your house; and if you couldn't afford a larger down payment in the first place, you probably don't have that cash to bring.

Without getting too deep into the mathematical weeds, the first-blush statistics should be enough to catch our attention. Buyers typically owe anywhere between 2 and 5 percent of the purchase price in closing costs, covering anything from loan origination costs to title searches to home inspections (and for FHA loans, those costs could be even higher, since FHA borrowers are required to pay an upfront mortgage insurance premium, typically 1.75% of the purchase price).

Then, when it comes time to sell, the seller is typically responsible for paying the realtor's fee, which averages somewhere around 6 percent of the sale price. That means we could be talking about as much as 10 to 11 percent of the sale price in total closing costs between a purchase and a sale of a house, which can lead to a stunning loss of flexibility for the homebuyer should they ever want to move from their first-time home.

All told, it can take anywhere between 3 and 6 years for the homebuyer to actually break even on their purchase, and that's barring a bad-luck scenario like the one that befell first-time homebuyers who purchased in 2005 to 2007, many of whom remain underwater.

In the context of a 30-year mortgage, 3 to 6 years might not sound like much. But when you consider that the average duration of a job holding in the United States is currently estimated at 4.4 years - and that for the younger generation, it's nearly half that figure - you can quickly start to see the problem.

For a generation that values mobility, and given a tight labor market in which labor force mobility is often essential, being locked into a negative cash position can present a significant problem. But if you've got enough equity in the house from the get-go, that kind of a problem can easily be avoided.

Think of a large down payment not as a pure financial decision, then, but as more of a lifestyle decision: putting more money into the house on the front end can be viewed as a type of insurance policy that protects against unforeseen job loss. Don't end up putting yourself in an uncomfortable position where you feel like you literally can't afford to move; wait until you can truly afford to buy your house, and enjoy the flexibility that your initial equity provides.

Your effective mortgage rate will be lower

While there are some exceptions, for the most part, low-down-payment mortgages will require that the borrower pay some sort of ongoing private mortgage insurance, which can increase the effective interest rate paid by the borrower.

Indeed, there is almost always some spread between the stated "interest rate" on the mortgage and the effective APR paid by the borrower. That difference accounts for the total cost of borrowing, after including and/or amortizing certain fees, including but not limited to points paid and mortgage insurance. Not surprisingly, that spread is generally largest for FHA-insured loans.

While truth in lending laws have gone a long way toward ensuring that borrowers are well-informed before signing on the dotted line, first-time homebuyers still might not fully appreciate how large an effective rate they are actually paying compared to other, more "traditional" larger-down-payment homebuyers.

Given the immense amount of media attention being paid to "record low mortgage rates" and the need to buy now before rates rise, it's important for buyers to recognize whether or not they are actually paying such low rates. But, again, if you wait until you have a large enough down payment to avoid private mortgage insurance, your rate really should approximate that "record low" rate, and not a significantly higher figure.

Many other countries (like Canada) have higher minimum down payments, and there is at least some speculation that those higher requirements could help mute real estate market volatility. It's altogether possible that an increase in low-down-payment mortgages will increase overall housing market volatility, an increase that could hurt those very low-down-payment borrowers the most. But until we know more about the long-term impact of a proliferation of low-down-payment mortgages (and it could take decades to know for sure), discretion will remain the better part of valor.

Yes, it's tempting to buy a house and to start building equity as soon as you can, and it's even possible that a rent-versus-buy analysis will recommend it. But just because you can doesn't always mean you should, and in almost all cases, it's best to wait until you have a larger buffer of home equity. Retaining financial flexibility is the name of the game, and a 3% down payment simply doesn't fit the bill.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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