Why You Should Put 20% Down When Buying a Home

The following is a guest post from the Virtual Money Coach.

Here is a very good reason to try and save 20% of the purchase price as a downpayment on your next house.  Most everyone is aware that if you put 20% down, the bank gives you the option of escrowing your taxes and insurance.  If you were able to save 20% in the first place, then you are probably pretty diligent with money and this strategy will work very well for you.
 
Let's assume that you bought a new house for $200,000 and put a 20% downpayment, financing the remaining amount of $160,000.  Your monthly payment consists of the principal and interest ($1,200) plus the taxes and insurance ($800), for a total of $2,000 a month.  Lets say that you clear $6,000 a month after taxes from your job.  Your monthly cash flow will look like this, assuming you are paid on the 1st and 15th of the month:

1st:
Paycheck                           $3,000
Mortgage                            ($2,000)
Other Expenses                  ($750)
Positive Cash Flow              $250
 
So for the first of the month, you have a positive cash flow of $250.  Therefore, your next pay period looks like this:

15th:
Paycheck                           $3,000
Other Expenses                  ($750)
Positive Cash Flow              $2,250
 
Notice how much extra cash flow you have on the 15th versus the 1st?  The mortgage payment is causing a tight cash flow on the 1st.
 
Now here is my strategy.  If you put 20% down on the house, you don't have to pay the taxes and insurance with your principal and interest payment.  You can save it yourself out of whichever paycheck you want (you must be very careful about knowing the exact amount you should be saving).  So look at the difference between making the principal and interest payment on the 1st and saving the taxes and insurances on the 15th:

1st:
Paycheck                            $3,000
Mortgage (P&I)                     ($1,200)
Other Expenses                    ($750)
Positive Cash Flow                $1,050

15th:
Paycheck                            $3,000
Save (Taxes & Ins.)              ($800)
Other Expenses                   ($750)
Positive Cash Flow               $1,450
 
Your positive cash flow for the month is still $2,500, but now it is spread out over both pay periods.  You will have more cash flow (and more wiggle room) on the 1st, just in case some unexpected expenses come up, and you know they will ;-)

Comments

[JACK]

this post implies that unless you have put 20% down you can't opt out of escrowing tax and insurance. Is that a new situation? I didn't put 20% down and escrow was completely optional for me.

[MonkeyMonk]

This is a sound system but only seems to be useful for those living paycheck to paycheck -- since if you have a cash flow buffer of 4-6 months then the cash flow inequity isn't that big a deal. Unfortunately I'd guess that people who live this way would have the hardest time coming up with the 20% down payment.

[Jeff J. Snider]

I'm not going to argue that you shouldn't put down 20% on your home, but I would argue that the reason presented here is almost entirely irrelevant. Why? Because we're talking about a mortgage that will span 360 months, but this entire post applies only to the very first month. Beginning with Month 2, you still have your $2250 positive cash flow from the end of Month 1, so you have your "wiggle room" built in. After the first month, if you are being responsible with your money, it doesn't matter even a little bit whether you are paying $2000 at once or splitting it over the two paychecks.

And when you consider that you generally don't have to make a mortgage payment until 45-60 days after you buy your house, this tip doesn't really apply to the first month, either.

[Randy]

If you have 20% for a downpayment - you are probably not living paycheck to paycheck. We use the YNAB approach to monthly cash flow - we spend the money we made last month during this month and bank our current month paychecks for use the following month. When we get paid doesn't matter.

[Emily]

First off, who's taxes and insurance on a 200K home are 800? And Why type of interst rate are you talking about? I think the reason you should put 20% down is so you dont have to PMI... Thats about it.

[PK]

I agree with Randy and MoneyMook insofar as this only applies to people that are living P2P and not buffering their expenses. I use YNAB and live off of last month's income so starting day 1 of the month I know exactly how much was left over from last month (turns into extra principal payment) and how much I can spend throughout the month.

[Blaine Moore]

I concur with everybody else - if you have a buffer of savings, then the inequity doesn't really matter. And Emily is right - the best reason to have 20% down is to avoid PMI, which is basically just an extra expense with no tangible benefit for you (only for the bank). The next best reason is because then you are at least 20% of the way through paying off your mortgage.

If you have the option, I'd recommend paying the expenses yourself if you know that you can save the money responsibly and then pay for taxes and insurance when it is due, but if you are apt to spend that money then you are better off escrowing it.

[Apex]

I know running a blog with fresh content is challenging but I just wanted to say that I am a little disappointed in the quality of posts going up lately. I think too much content is being put up by others and it's not getting a strict enough vetting. Just my opinion.

As everyone already pointed out, the rational in this post is not wrong, just irrelevant.

In addition, my experience (and I just re-fi 3 weeks ago) is that if you are on the cutting edge of rates which I was (30 yr, 4.375) they are going to require escrow or else they are going to bump the rate. I have had this happen to me on other re-fi situations too. This may not always be true but it has been for me. Even the slightest increase in rates would make the option not to escrow into a money loser.

[FMF]

Apex --

I can understand your point. My take is that I like to allow other authors a forum to express their ideas without me editting them. Then the ideas can live or die on their own merit and the author's ability to express them, not on me managing, re-writing, etc. them.

As such, in general, I opt for more different points of view. Maybe this is a poor approach...

[Apex]

FMF,

Appreciate you addressing that directly and explaining your view. And just to be clear on my comment, I have found many guest posts here quite valuable. And while I disagreed with some, those too were at least thought provoking. The last few days it just seems like some "fluff" has made it up. :)

[sr]

800/month for taxes and insurance..... stopped reading at that point

[Education Works]

This example serves a good, very basic concept. From someone who happens to have experience in the mortgage industry, people focus too much attention on payments and interest rates and forget that, as this simple example demonstrates, any borrower with an average intelligence prefers to have better control of personal cash flow instead of allowing someone else to "do it for them".

The $800/month in the example appears to be reasonably accurate when taking into account property taxes and multiple forms of insurance. As far as paying a slightly higher APR for NOT having an escrow (or impound) account, I have yet to meet a professional real estate investor who balked at the interest rate WHO HAD BEEN IN THE BUSINESS FOR MORE THAN JUST ONE OR TWO YEARS. Adding an escrow account "as a convenience" translates, "Instead of YOU using these funds to benefit YOU, why don't WE use YOUR money to benefit US?" Imagine the difference as illustrated in the above example meaning the difference between paying off a 30-year mortgage in 360 payments or reducing the time to less than 10 years!

Good example!

[George]

You stopped reading after $800/mo taxes and insurance??? I have seen places where that might not be too far off...and the author was obviously using easy numbers to round to make his point. If you were going to stop reading..you might have done so at a $1200 mortgage payment for a $160k loan....that's about 8.25 % interest rate for 30 years...which I assume is the case if they are considering less than 20% down. This to me is less likely than the $800/mo in taxes and insurance especially for someone who nets $6k/mo.

I agree with APEX - i have tried to get out of escrow but my last couple mortgages wouldn't let me.

Thanks FMF for allowing alternative posts and points of view. I still enjoy reading the issue and get as much out of the comments even if I think the original logic is a little flawed.

[ThinkingFinance]

The best reason to put down 20% is to avoid PMI, its an extra charge because the bank thinks you are a higher risk loan.

Don't put more than 20% down -- you're better off using the banks money. Cash in your pocket is preferred over having cash in an illiquid investment like a home.

Getting a loan for less than 20% down is much harder in this environment with more stringent lending requirements as well.

Happy house hunting...

[Apex]

@Education Works

So you argue that its better to pay a higher interest rate to get out of Escrow so you can have control over your money and not have them "use it" while they hold it? What were you expecting the person to do with it in the 6 months that it is accumulating before the semi-annual tax payment is made? Lets do some math:

Escrow account that fluctuates between 1K and 4K while it's accumulating before taxes or insurance is paid (and I think those numbers are pretty high for a 250K house). Average Balance of about 2500 over the course of the year. Figure 2500 @5% opportunity cost (which you can't get anything close to that right now) and you have $125 in "cost" for the "convenience".

200K mortgage at 1/4% higher interest is $500 more per year in interest payments, which is a typical increase in rate for not escrowing. Even if you managed to get it for 1/8% higher rate, thats $250 in higher interest payments per year.

The cost of the higher rate is much higher than the savings by "controlling" your money.

[George Y]

I put down 20% on a $260K house and was not given the option of no escrow. I tried to close it after the fact, but the bank required a new appraisal ($300 min) to ensure the equity was still greater than 20%. My main reason to try and get out of the escrow was that they require a balance "buffer" that the account cannot drop below, which amounts to an extra $800 of my own money that they get to hold until the escrow is closed. Escrow is just another money maker for the banks.

[Jim]

There are good reasons to have 20% down payment. You avoid PMI. You face lower risk of getting in a negative equity situation.

It doesn't seem good to be that concerned with cash flow on a week to week basis. This looks like living paycheck to paycheck and if you're doing that then you should not be buying a house.