HOW IT'S BETTER TO BUY A HOME IN PHILLY WITH LESS THAN 20% DOWN PAYMENT

Your parents probably ingrained in your head the old standard that you must put 20% of the purchase price as the down payment for a home. But the economy is different these days, and that old 20% relic is becoming outdated in a lot of scenarios. When you can put down as little as 3%, a lot of people are realizing they’re wasting time and money on rent when they can be building equity every month — sometimes for an even cheaper monthly cost than their rent! The cost of the mortgage insurance between 3% down payment and 20% equity is often negligible compared to the financial gains of homeownership. Let’s look at an example.

Let’s say you have been saving up for a $250,000 home. Your ideal down payment is 20%, because you don’t want to pay that pesky PMI — so your savings goal is $50,000 (+ closing costs, of course). Right now, you have about 10% saved up, with $25,000 sitting in your bank account. You estimate it will take you another two years two save up the additional $25,000 for the down payment. 

What’s happening in those two years?

  • You’re losing two years worth of rent money, which your landlord is collecting to build his own equity. In August 2019, the median rental price of a mid-tier single family home in Philadelphia was $1346. So over two years, you’re spending $32,304 in money you’ll never see back.

  • Homes are appreciating. The $250,000 homes you see on Zillow now may very well be out of your price range in just two years in some markets (especially Philadelphia these days). Meanwhile, the houses will be at $250,000 two years down the line are currently priced around $230,000 — a price that you’re missing out on. 

Let’s play devil’s advocate. What would have happened if you bought the house now instead of waiting two more years to have the full down payment?

  • You have two options for buying a house, you can either buy that $230,000 house that will appreciate over the couple extra years you own it, or you can buy the house that is currently $250,000 that you wouldn’t be able to afford in two years. So you’re either saving $20,000 on your purchase price or you’re getting more house than you would be able to afford otherwise.

  • You use the deposit you currently have (or less) and start a mortgage. You are paying PMI of approximately $103-$154 per month. So that’s the money on your monthly mortgage payment that isn’t going towards your own equity or tax-deductible interest — much less than the $1346 in rent that you weren’t getting any returns on (keep in mind, once you hit beyond 20% equity, you can get rid of the PMI payments).

  • You’re also about two years ahead on throwing your personal touches into your home. You have more freedom to sell, refinance, and rent than two years down the line when you’re only just freshly getting into the game.

  • You have some money left over in your bank account by using less than what you already have saved, providing you with a nice cushion and comfort: AND you get to keep accumulating that $25,000 you would have saved over the next two years and use it for whatever you want, instead of a down payment which you already have.

Want to see more of the math? In this chart, two examples of paying lower down payments are computed. This analysis factors in PMI payments, monthly vs. overall payment accumulation, and total dollars gained or lost compared to renting for two years while you save up that 20%. The third column shows the same details for making a 20% down payment — two years down the road when you start off with $32,304 less than in the other scenarios.

For consistency across scenarios, we assumed a 4% interest rate and a credit score between 700 and 719. A 28.95% income tax rate is used based on 2018 and 2019 Federal, State, and Philadelphia rates. Our resources listed below will help you generate projections for other scenarios that may better represent your own situation. Keep in mind, any 20% down payment figures are for your reference for what you would be paying down the road in two years when you have the full down payment. These figures are not concurrent with the 5% and 10% statistics, which have a 2-year headstart. The 20% figures are included for your reference to see the difference in the breakdown that having the full 20% results in.

Down Payment Comparison Philadelphia.png

BUYING A HOME IN PHILADELPHIA: DOWN PAYMENT AND SAVINGS CALCULATIONS

*Closing costs are not included in total savings between buying in year zero or when you have a 20% down payment in year 2. This is because you will be paying similar closing costs regardless of the scenario, with a differential of less than $500.
** Real estate tax average per year is $2,373 for a Philadelphia home worth $250,000 as of 2019.

HOW MUCH MONEY DO YOU SAVE BY PUTTING DOWN LESS?

As you can see, regardless of which scenario you choose, your monthly housing payment in Philadelphia is going to be cheaper on a mortgage than on someone else’s rent roll.

If you add up all the payments you made in the two years you would have been renting while saving up more to make a 20% down payment, you would have a total cash outflow of $53,080.87 at a 5% down payment, and $61,799.48 at 10%. If you were renting over those two years, your total outflow would have been $32,304. So you may be saying it’s cheaper to keep renting, right?

With purchasing, a lot of the cash outflow over the two years is still yours — it’s just in the form of equity, and savings in your pocket that you would not have had if you waited two years to purchase and put more of your liquid cash into the down payment. Besides the property appreciation, tax breaks, and equity from your down payment and principal payments over two years, you also have saved by holding on to the liquid cash that you would have used in your bigger down payment. This liquidity might be even more valuable than the other savings, as cash-in-hand is often worth more than illiquid and future assets.

To make your savings estimates when putting less than 20% down on a house as conservative as possible, let’s take out the appreciation in these total savings. You can only go up from these numbers. These are the savings compared to if you waited two years and bought a house with 20% down as in the chart.

Total savings over 2 years at 5% down payment (not including property appreciation): $50,432.42 

Total savings over 2 years at 10% down payment (not including property appreciation): $35,770.62

This actually even suggests that you’re better off putting less money down. And keep in mind, both these figures take all PMI payments into consideration.

So to recap the pros of paying a lower down payment over waiting to have 20% saved:

  • You got more house for you dollars — either you bought the same house you would two years down the line, only earlier and for cheaper, or you bought a house now that you wouldn’t have been able to afford if you waited for your 20% down payment to trickle into your bank account.

  • You are two years ahead on unpacking, doing renovations, and putting all your personal touches into making your house your home. You’ve been living in the freedom of doing what you want, how you want.

  • You saved tens of thousands of dollars in just two years.

  • You have more liquidity available than you would have if you saved 20%; this enables you to improve other facets of your life like hobbies, education, family, travel, etc.

And to give the scenario a fair shake, keep these potential cons in mind for your individual situation:

  • Purchasing comes with a lack of economic and leisurely mobility: If you plan on moving in the next few years and would sell the house, it may not be worth the transactional costs of purchasing a home. Similarly, if you are not ready for the responsilbiity of house and property maintenance, renting may still have a higher personal value for you. In this case, it may be worth it for you to wait and keep saving for when you’re ready to take on a house.

  • Overall you will be cash flowing out more than if you rent; but overall, you are both saving and making money by investing in ownership. If illiquidity may be difficult for you to manage, it may be worth waiting and saving so that you can apply your cash to other facets of your life that make day-to-day costs manageable. Whether you’re buying now or in two years, purchasing requires high up-front costs.

  • You pay a maximum total of $8,353.53 (at 10% down) to $16,209.90 (at 5% down) in total PMI. You wouldn’t have had to pay this if you had 20% down payment.

TOTAL INTEREST AND PMI PAID OVER THE LIFETIME OF EACH LOAN

The total savings in these scenarios already account for PMI and interest paid over this time period. While it is true that over the lifetime of the loan, you would pay a maximum of $16,209.90 or $8,353.53 in total PMI on 5% and 10% down respectively, this cost is well worth the financial gains of holding on to the house asset for longer than waiting until you have 20% down payment savings. Those figures are only true net costs if you had the 20% down payment now rather than two years down the road, and chose to only put down 5% or 10% and save the rest. Even then, there is the economic theory that cash in hand in the present has a higher value than savings in the future, and so it is arguable that in some cases, it may even be better to put down less even if you have more capital available to put down. Of course, everyone has different opportunity costs and the value of liquidity, investment, and immobility differ from person to person.

Your real estate agent and lender can help you understand your specific scenario better, but this example is widely applicable to most home-purchasers. With interest rates as low as they are lately, these numbers would turn out even more in your favor. You have to choose the right loan product, your down payment amount, account for closing costs, and then when all is said and done, you can even get rid of that PMI early (in case that monkey is trying to hang on to your back).

Here are the resources used for our example so that you can work out projected numbers for your specific circumstances:

Philadelphia Home Prices and Values Index

PMI and Amortization Calculator

Philly Real Estate Trends and Housing Market Data

Philadelphia Closing Cost Calculator

Philly Property Tax Calculator


Methodology:

  • Cash outflows = (down payment $ + 23*total monthly mortgage payment + total PMI paid over first two years + home insurance paid over two years + real estate tax paid over 2 years)
    ^ Down payment is not counted in cash outflow because the same/similar amount would be paid out in two years when you purchase the property with 20% down. So comparing then at 5% or 10% or later at 20%, the down payment outflows would cancel each other out.

  • Conservative estimate of various equity inflow over 2 years = Cash, equity, and opportunity cost inflow over 2 years = (tax savings through interest paid in first 2 years + equity after 2 years without appreciation + total projected rent costs over 2 years + amount of down payment savings left in your bank account after 2 years)

  • Estimate of various equity inflow over 2 years including appreciation = Cash, equity, opportunity cost, and property appreciation inflow over 2 years = (tax savings through interest paid in first 2 years + equity after 2 years including projected appreciation + total projected rent costs over 2 years + amount of down payment savings left in your bank account after 2 years)

  • Total savings over 2 years (with appreciation) = Cash outflows - (cash, equity, opportunity cost, and property appreciation inflow over 2 years)

  • Conservative estimate of total savings over 2 years (no appreciation) = Cash outflows - (cash, equity, and opportunity cost inflow over 2 years)