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Down Payment and Why It Matters 5% or 20%?
What is downpayment?
Downpayment is the amount of money you are going to put into the property. Let’s say you are buying a $400k property 123 main street, and you have $50k in your bank account. You take that $50k and use it to purchase ownership in the property 123 main st. Since you put $50k down of the 400k needed to purchase 123 main st you own 12.5% of the property. $50,000/$400,000= 12.5% What about the other $350,000? This comes in the form of a loan from a bank, the bank is going to loan you $350,000 of the $400,000 in order to purchase 123 main st. In return you are going to be making monthly payments to the bank for 30 years until your loan is paid off or until you sell the property. Your interest rate determines how much the bank is going to charge you for lending you the $350,000.
In the above example your down payment would be 12.5% because $50,000 is the amount you brought to closing of the total $400,000. $50,000/$400,000=12.5%
Why does down payment matter for buyers?
Down payment amount has an inverse correlation with monthly payment. So the more downpayment you put down the less your monthly payment will be.
Let’s assume a for the above example 123 main st, that the bank is giving you a 5% interest rate on a 30 year loan, 0.5% PMI
If you put 12.5% down on $400k with a 5% interest rate and 0.5% pmi your payment comes out to $2024.71/month (mortgagecalculator.org)
If you put 18% down on $400k with a 5% interest rate and 0.5% pmi your payment comes out to $1897.44/mo (mortgagecalculator.org)
Less down payment is more risk for you as the buyer
The less the downpayment you put down on a home, the bigger the loan is. The bigger the loan, the more risky the investment for you and for the bank. A higher payment/month has a higher chance of being missed than a lower payment per month. For example our two scenarios above with 12.5% down and 18% down the monthly payments are only about $100/mo different, but $100 is $100 and if things get tough and you get fired from your job you are more likely to pay $1897.44/mo than $2024.71/mo. The bank sees it the same way, the more downpayment you put down, the less risky you are as a borrower. (Borrower means someone who has taken a loan out)
In general more leverage=more risk for any investment, stocks, bonds, farm equipment, real estate, etc, but managing your ability to repay and what you think your income is going to look like in the future will play into how much downpayment you should put down.
PMI is Private Mortgage Insurance- this is an additional payment that is tacked on to your monthly payment if you put less than 20% down payment. It is tacked on because you are viewed as a riskier borrower to the bank because you don’t have a lot of skin in the game (equity). Equity is the amount of ownership you have in the property, so if you put 12.5% downpayment down you have 12.5% equity. Once you reach 20% equity the bank views you as a solid borrower and they don’t feel the need to insure themselves against any missed payments. PMI protects the lender (bank) not you.
PMI tends to be about 0.5% of the loan amount added to your monthly payment so for example with our 12.5% down payment scenario your payment is $2,024.71 with $145.83/mo being for PMI. If you were able to put down 20% down payment on a 400k purchase price your payment drops to $1,717.83 with $0 being paid towards PMI.
Conclusion- The bank gives you incentive to bring equity to the table and put skin in the game because they are risk averse and want you to be able to make your monthly payments with ease even if you get fired from your job. 20% down is a lot of money and it may not be the right option for you, 5% down may make more sense. It really is a case by case basis.
Why does down payment matter for sellers?
Downpayment is another word for risk in the seller’s eyes
For a seller, more down payment is less risk. As a seller you want to see offers that have high down payment amounts because there is a higher chance the bank will agree to give the buyer a loan. As a seller you want the buyer to get a loan because if they do not get the loan they will not be able to purchase your property and they will cancel the contract and you will have wasted a lot of time on the market when you could have been under contract with the buyer who had their finances in order. The longer a seller sits on market the less desirable the house gets in the eyes of the buyer which leads to more negotiating and lower priced offers.
Appraisal Coverage
Also if any issues arise with the appraisal, the more down payment the buyer has the more likely they will be able to cover gaps in the appraisal. For example if you have a contract price of 500k and an appraisal comes back at $480k that is a $20k gap. Someone who is only putting a downpayment of 5% will not be able to come up with the additional $20k needed to close the deal. A buyer putting down 15% would be able to put down 10% instead and come up with the $20k needed to cover the appraisal gap.
Pros + Cons of a small down payment
Pros
Cons
You are able to buy a home quicker than if you were to wait and save up let’s say 20% down payment. This allows you to capture the appreciation in the real estate market which is your golden ticket to wealth!
Higher monthly payment
Your cash is not trapped in the property, you have liquidity to invest in more properties instead of just purchasing one
PMI-The lender will consider you a more risky borrower so you will have to pay PMI
You have extra cash to fix the property up
Higher interest rate- because you are doing a low down payment loan your interest rate might be slightly higher
You have some extra cash for family emergencies
May have trouble getting an accepted offer if we are competing against other buyers with large down payments. Sellers prefer larger down payments
More interest paid on the life of the loan
Pros + Cons of a large down payment
Pros
Cons
Lower monthly payment
It takes you longer to buy a property because you have to take the time to save up
Lower interest rate
Your cash is trapped inside the property
No PMI at 20% down
May not have emergency money for your family
You have more negotiation power with sellers because your offer is stronger
Stressed out because you put all your money into the property and you are tight on cash
Less interest paid on the life of the loan
May not have money to fix the property up
Down Payments By Property Type
Condos
Since with condos you are buying a shared interest in a large association the lender takes extra cautions to protect themselves. The lender is going to review the budget for the whole association and determine if it is being run properly or if they are being risky and not collecting reserves. (reserves is money that is set aside for the inevitable repairs that will need to take place at the association)
If the condo has enough reserves (10% of the budget) you can put down as little as 5% typically, if the condo does not have reserves you typically need to put down a minimum of 20%. That way if something happens the bank is confident you will not just walk away from your 20% equity and if for some reason you do walk away from it they will be able to sell the property and not lose any money.
Single Family Homes
Down Payment with single family homes typically has no reservations like condos do, the minimum down payment is normally 3.5%
Investment Properties 1-4 units not in an LLC
Investment properties can be purchased with as little as 15% down
Majority of people try to get a 20% down payment for investment properties.
If you are purchasing a property in an LLC that will require a commercial loan and that is a minimum requirement of 20% down payment sometimes even more
Multi Family in an LLC
Down payment on multi-family properties (5+ units) will require a minimum of 20% down and the down payment amount will actually be determined by what’s called the debt service coverage ratio. This ratio needs to be 1.25 or higher. It means that the property is making 25% more per year than it costs to pay the mortgage. A ratio of 1.0 would mean the property is breaking even and a ratio of 0.95 would mean the property is losing 5%.
DSCR= Debt service coverage ratio
NOI= Net Operating Income
Debt Service= Principal and Interest
DSCR=NOI/Debt Service
Debt service=noi/dscr
In order to calculate debt service we need to know how to calculate NOI
Net operating income= Gross operating income- operating expenses
NOI= all income collected- Management fees + Taxes + Insurance + Utilities)
If a property has a gross operating income of $120,000/yr and operating expenses of $50,000 what is the NOI?
$120,000-$50,000= $70,000 NOi
Example if we are purchasing a property that has a NOI of $100,000 per year. The lender requires a 1.25 DSCR, what will the maximum debt service be?
Debt service= NOI/DSCR
Debt service= $100,000/1.25
Debt service= $80,000
Real World Offer Scenarios
Scenario 1
Let’s say you put an offer in on a condo that was listed at $400k that has 10% reserves. We offered $415k and have a downpayment of 5% with no appraisal contingency
A second competing buyer put an offer in on the same condo for 415k as well, but has a downpayment of 10% with no appraisal contingency
A third competing buyer also put an offer in for $415k and has a downpayment of 15% with no appraisal contingency
Assuming all the buyers are equally qualified and the offers are the exact same with the only difference being the down payment amount, the seller is going to accept the third offer because it has the highest chance of closing especially with no appraisal contingency. If the sellers were to accept the 5% down offer and the appraisal came back lower than the contract price the buyer would have to come up with extra money somehow whereas the 10% and 15% already have it there, they would just take it out of their downpayment.
Scenario 2
Let’s say you put an offer in on a single family home that is listed at $800k. We offered $790k and have a down payment of 10% with no appraisal contingency
A second buyer has an offer in for $780k with a downpayment of 20% and no appraisal contingency
A third buyer has an offer in for $800k but has a downpayment of 5% with no appraisal contingency
This scenario is a little tricky. All of these offers have a different price and risk factor and depending on how quick the seller needs to sell, how much money they need and other matters they will choose the best offer for them. Some people sell because they want to move properties and they need a certain amount of money from their current home to purchase their next home. Some people run into family emergencies and need to sell because they need the money for medical bills. Each seller is unique, just like each buyer. The riskiest offer is certainly the third buyer because of the low down payment, but it’s going to put the most amount of cash in the seller’s pocket. Our offer, or the first offer, has less risk than the third offer, but would put less cash in the seller’s pocket. The 2nd offer has the least amount of risk, but also puts the least amount of cash in the seller’s pocket. At this point anything could happen; it truly depends on the sellers needs and risk tolerance.
Alec’s Opinions
Down payments at the beginning of your real estate investing career
When you are just getting started in real estate the only things that matter are getting into the market as fast as possible, any way possible, with any location possible. If you do not own real estate you are not capturing the benefits of appreciation. In real estate TIME IN THE MARKET is the most important thing. Time in the real estate market will make you very rich, so if that means putting down 5% instead of 20% because it will take you another year to save up the 20%, by all means put down the 5% and buy a place. In the year you spent saving up the 20% down you could have made a lot of money in appreciation. Maybe you have more than 5% down, maybe it’s 12% down. Whatever you have now in this very moment put down, just get into the market asap!
Once you have a couple properties
As you get deeper into your real estate investing career you can start waiting until you have 20% down because you can start cash out refinancing properties to buy more properties. Once you have 5 properties things become very easy, but those first 3 are very tough!
Should you pay off your property early?
I believe you should not pay off your property early, I instead think you should use the cash you would use to pay off the property to purchase even more property. Let’s say you own 1 property and over the course of the past 2 years you have made $50k from that property in appreciation. Instead of paying off the property you already have, buy another property so you have 2 properties both making $50k in appreciation every 2 years. That way you are making 100k every 2 years while your renters are making the monthly payments for you. Your renters can pay your properties off for you, you don’t need to. I hope you can see that as you accumulate more and more properties and start making more and more money off of appreciation the richer you become. You are then able to cash out, refinance these properties and take the money and buy even more properties which will yield you even more appreciation. If you had 10
properties all making you $50k every 2 years in appreciation that’s $500k every two years! That’s the power of real estate.
Determine what is best for you
You know your situation better than anybody and analyzing the information you just read should help you determine what is best for you given your current situation. If you have additional questions or concerns or want to bounce some ideas off of someone, reach out to me and I would be happy to talk with you.
Conclusion
Early in your career you should focus on obtaining as many properties as possible with as little down payment as possible so you can reap the rewards of appreciation, depreciation, cashflow, leverage, tangibility and diversification. The Big 6. Once you get your snowball rolling downhill it will turn into a humongous snowball and it will be this big cash pile that is always chasing you down the hill. Once your snowball is large enough, then start to mitigate risk by buying property only when you have the option to put +20% down. The more properties you have the less risk you have because if one property is vacant because the renter moved out, you are collecting many other rent payments and can easily afford to pay the mortgage on the vacant property.
