When Does It Make Sense To Put Less Than 20% Down On A House

Financial advisors and even real estate experts frequently extol the virtues of making a down payment of at least 20% on a house. But are there times when it makes sense to put less than 20% down on a house?

Actually, yes. In fact, there are several situations where it makes sense.

One of the major dilemmas that homebuyers face is a shortage of cash after closing. This is a bigger problem than is usually anticipated prior to closing. Once you close on a home, you’ll have other expenses. Some of them will be related to the property itself, but others can be unanticipated expenses.

For example, once you move in, certain repairs may be necessary. They may not happen in the days and weeks after closing, but they frequently turn up shortly after. Other times you find that you need new necessities. This could include an appliance or two, or even some furniture.

The point is, you’ll have additional expenses, and a very difficult time. Since most people increase their monthly house payment when they buy, cash is already tight. But, if you have several thousand dollars worth of expenses shortly after closing, it creates a certified cash shortage.

This can make your early days as a homeowner very uncomfortable.

An alternative is to make a minimum down payment on a house, and keep as much money in the bank as possible. That will keep you liquid during those crucial early months. And that can prevent a lot of other problems and stresses.

One of the main reasons for putting down at least 20% is to lower the risk of owning a home. But if the house you’re buying is well below what you can afford, it’s already a fairly low risk proposition.

And since you can easily afford the monthly payment, the likelihood of needing to sell diminishes.

For example, one of the major reasons to make a large down payment is so that you have enough equity that if you have to sell quickly, you could do so and walk away with cash after closing—or at least not have to write a check at the closing table. But if the monthly payment is well below what you can afford—as in well below the normally required 28% of your stable monthly income level—the likelihood that you’ll need to sell quickly is remote.

Making a large down payment is usually recommended if you’re in a flat or declining housing market. Since prices aren’t rising, you won’t be able to increase your home equity through housing appreciation. A 20% down payment (or more) gives you a comfortable equity cushion.

But if you’re in a housing market that’s seeing values rise quickly, there’s less need to have a large equity position. Since the house can be reasonably expected to increase in value due to market factors, you’ll increase your equity without having to pay extra dollars to make it happen.

For example, let’s say you’re in a local market where property values are increasing by 10% per year. If you make the 5% down payment, one year later you’ll have 15% equity. Two years later you’ll be up to 25% equity. The need for a large down payment is less important in that kind of market.

Once again, making a large down payment is about lowering the risk of homeownership. But if you’re in a very strong financial position, particularly one where you have a lot of other assets, there isn’t much risk anyway.

Let’s say you’re buying a house for $300,000. If you make a 20% down payment, you’ll need $60,000. If you make a 5% down payment, you’ll only need $15,000.

If you have $100,000 in savings and investments, you may actually be in a lower risk position by making the 5% down payment. That will leave you with $85,000 in savings and investments, compared to just $40,000 if you make the larger 20% down payment.

In a situation like this, the smaller down payment is mostly a convenience

You’re in a position to make a 20% down payment, but you don’t actually need to. You’re simply preserving more of your savings and investments by making the smaller down payment. And in doing so, you’re not increasing the risk of homeownership.

What’s more, if you’re currently earning more in investment returns on your savings and investments than you will pay in interest on the mortgage, then you’ll have a financial advantage by retaining as much of your savings and investments as possible.

For example, let’s say you’ve been consistently earning about 7% per year on your savings and investments. The interest on the mortgage will be 4%. Any money that you don’t use toward the down payment will have a net return of 3%. You’ll be paying 4% on the higher mortgage balance, but since you’re earning 7%, you still come out ahead.

Picture this: You and your spouse are living in a cramped one-bedroom apartment—but you’re expecting twins in a few months.

In that situation, your need for housing space is about to increase dramatically—but your living space isn’t.

What to do?

Your situation is about to change dramatically, and you don’t have a lot of options. But you have just enough to make a minimum down payment on a house.

In this situation, your housing needs are about to overwhelm your finances

You need more space immediately, but you don’t have time to accumulate a larger down payment. A minimum down payment is the only way you’ll be able to afford to buy a house.

If your finances can accommodate it, you may need to buy a house with the smallest down payment. Naturally, it will go better for you if you’re buying less house than you can afford. And it will be even better if you have rich relatives to turn to if things turn sour.

There’s nothing wrong with making a minimum down payment on a house—IF there are offsetting factors. Those factors include having a relatively low monthly payment, plenty of other assets, or rich relatives who are more than willing to help.

When all is said and done, sometimes it does make sense to put less than 20% down on a house.