Down Payments Are So Tricky as a Housing Bubble Brews

(Bloomberg Opinion) -- The 2022 homebuying season is kicking into high gear, and it's even more frenzied this year as rising mortgage rates and record-low inventory push buyers to act quickly.

All-cash offers have been the buzz of the past year but most people can't afford them. The more pressing question for anyone seeking to finance a home purchase is how much to pay upfront. In such a hot market, a higher down payment can give buyers an edge in a bidding war, but is there a limit to how much of your savings you should be tying up in your home?

That's a particularly important question amid skepticism that the housing market's record price appreciation will continue. (Case in point: A recent report from the Dallas Federal Reserve Bank says there are signs of a U.S. housing bubble brewing.)

On the other hand, less cash-flush borrowers may be wondering how low is too low for a down payment in this environment. Even if they're able to win the contract with a smaller down payment, they'll be facing a bigger monthly mortgage bill at higher interest rates, plus paying for private mortgage insurance if they put less than 20% down.

Here's a quick recap on how down payments and mortgages work:  Some loan programs allow eligible buyers to put as little as 3% down. With any down payment smaller than 20% of the home's purchase price, a bank will typically require the buyer to obtain private mortgage insurance as part of the monthly expense to compensate for the higher risk the bank is bearing.

So let's first consider the pros and cons of putting down more than 20% -- which is even more likely now as many homeowners will reap big gains from the sale of a prior home. My advice would be to go for it, provided you have the means to do it and really want the house. Consider this: Putting more than 20% down increases an offer's competitiveness by 31%, according to Daryl Fairweather, chief economist at Redfin.

A bigger down payment is especially attractive to sellers these days because of appraisal issues. Appraisals are generally based on comparable sales from two or three months ago and may not reflect current home values in some markets. Given the intense competition, homes are sometimes being appraised for less than buyers are offering to pay. The extra down payment can act as a buffer to bridge the difference and give you an advantage over someone who's offering to put down less.

Now, if you're worried about putting too much down and home prices collapsing, remember that while demand may eventually cool following rate increases and out-of-reach prices, supply is forecast to remain tight. That may lead to more moderate price increases but not an actual decline. And as the Dallas Fed report highlighted, household balance sheets are in better shape and there isn't excessive borrowing, so this isn't 2007 all over again.

In addition to saving interest over the life of a smaller loan, there are other benefits from making a bigger down payment. For example, a borrower who puts 20% down and has a credit score of 700 may face what's known as a risk-based fee of 1.25% of the loan amount, which could be baked into the interest rate charged, says Keith Gumbinger, vice president of mortgage loan website HSH.com. The fee drops to 0.5% when you put 30% down and disappears for a down payment of 40%.

Still, even if they can afford to, younger homebuyers might prefer to put more of their money in the stock market than tie it up in their homes, since over the long term, stock market returns are likely to outperform home price appreciation, says Kevin Mahoney, a certified financial planner in Washington. Likewise, those who don't anticipate staying in their homes for very long may want to put down less.

For those who are skittish about putting a lot less than 20% down, let me provide some perspective. Most people put down less than 20%. The median down payment was 13% in 2021, according to the latest figures from the National Association of Realtors -- in line with where it's been for the last four years. Even for those who were repeat buyers, the median down payment was just 17%.

And yes, rates are climbing, but they're still historically low. As long as you've calculated what your monthly payment will be and are comfortable with it, you shouldn't let the fact that it could have been lower a year or two ago drive your homebuying decision today.

It's also important to keep some cash reserves instead of putting it all into a down payment. First-time homebuyers especially often underestimate how much they'll need to spend on things like landscaping or window treatments, or unexpected repairs.    

If you're worried about the cost of private mortgage insurance with a bank loan, keep in mind that after five years you can request to cancel it if you've attained 20% equity in your home (the difference between the current value of your home and how much you owe on your mortgage). If you get to 25% equity, you may be able to cancel after just two years. You might hit that faster than you think thanks to increasing home values.

Much like the antiquated rule of thumb about not spending more than 30% of your income on rent, the guideline that you should only make a down payment of 20% -- nothing more, nothing less -- just isn't very useful anymore.

More From Other Writers at Bloomberg Opinion:

• Mortgage Rate Surge Won't Reverse Home Prices: Jonathan Levin
• Consumer Despair Is Likely Worse Than We Realize: Jared Dillian
• A Stronger Housing Market Can Withstand a Hawkish Fed: Conor Sen

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.

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