Tuesday, November 1, 2011

The case for 20%

Getting back to basics as a personal finance blog, I’d like to quickly explain some of the benefits of putting down a significant amount of money when purchasing a house. Personal finance books often recommend at least 20%, so we’ll try to spell out why the smaller down payments often leave you vulnerable to forces beyond your control.

First, remember what the concept of marginal utility of wealth is? It’s basically the idea that, as one gets richer, increments of extra income don’t bring as much happiness as they do when one is poor. Once you’ve got the basics in life covered, an extra few grand doesn’t make that big of difference. This seemingly tangential point should be ingrained in everything one does when it comes to money. Essentially, it makes you want to protect your downside rather than making risky bets that could net you a few more thousand dollars.

For example, borrowing a lot of money for a house is a risky venture; it just seems less risky cause so many people do it. While you may enjoy rising house prices and be able to lock in a capital gain, there are a couple of scenarios that could wipe you out. The main one is that house prices could trend down after you purchase your home. If one put a pittance down on the house in such a scenario and need to move and sell the house, they’ll need to come up with cold hard cash to pay off the loan.

The scary thing is that we can’t do a damn thing about house prices, and no, they don’t always go up, as was the refrain in the late 2000s. Felix salmon here explains why owning a house is like owning a small business you have no control over (or like gambling, as he calls it). People with adjustable rate mortgages or a volatile job outlook are especially vulnerable to these types of situations, as the former are forced to move or refinance after a few years and the latter may have to move and find a job (paradoxically) to be able to afford their mortgage. One under-repeated fact is that you can’t refinance your house (and lock in a lower, or simply a fixed rate) unless your equity amounts to about 20% of the home’s value. With house prices have gone the last few years, more than a few have been caught with little skin in the game and thus are literally stuck in their houses if they don’t have lots of cash (~23% percent of Utahns are underwater as are ~60% in Nevada; see here).

Other benefits of putting down 20% include the fact that you don’t have to pay private mortgage insurance (~$100/month) and you can lock in a lower rate by refinancing if interest rates go down (saving you thousands over the life of the loan). Yes, by putting a small amount down, you could juice your returns through leverage, but if prices don’t move your way, you could end up having to pony up $20,000 or $30,000 (or more) when selling the house. I know which of those two scenarios would have the biggest effect on my happiness. Perhaps if people realized they have to pony up $40,000 (for a $200,000 house) or $60,000 (for a $300,000 house) to properly purchase, we wouldn’t have such homeownership euphoria in this country.


  1. Hey Levi - love the blog; the one about the Euro was especially informative. I totally agree with you about the need to have 20% down on a home (we didn't have it on my first home and I really wish we would have waited). I tell this to my friends and they ask me why and I haven't always been able to come up with the best answers, so now I can point them to this post.

  2. Thanks for the note, McKay. I hope things are going well. Glad to hear you're not swept up in the leverage-it-to-the-hilt mania like most people.