Skip the 20% Down Payment

Selena Maranjian

Conventional wisdom holds that it's best to buy a home by paying 20% of its price up front. That spares the buyer the expense of private mortgage insurance (PMI), and provides lower monthly payments to boot. Now that the subprime lending crisis has erupted, hurting profits in investment firm Bear Stearns, homebuilders like Pulte Homes, and lenders such as Citigroup, Freddie Mac, and Countrywide , the responsible 20% down payment seems even harder to argue with.

But Cortni Marrazzo at savingadvice.com recently offered a provocative counterpoint, making a good case for forgoing the 20%-down route. Here's why:

  • When the homes in your region typically cost $200,000 or more, 20% means coming up with $40,000 or more in cash. Few people can do so without raiding their retirement savings or other vital funds.
  • If you plan to wait and save up that $40,000 over time, it will probably take you a long time to do so -- several years at least. During that time, the average price of homes may increase, so you'll end up needing to save even more.
  • The money you plow into that down payment might be better deployed elsewhere, such as in a retirement account, an emergency fund, and even in home improvements to make your new home more valuable. Marrazzo makes this critical point: "Chances are, if you are saving a huge chunk of money each month for a large house down payment, you aren't contributing the max to your retirement account. Your early investing years are the most critical for your future, because of the wonderful concept called compounding interest." That's very, very true.
  • While you wait and save, you'll be spending money on rent that could have been spent building equity in your new home. You'll also be missing out on some mortgage interest deductions on your tax return. And since these accumulating dollars shouldn't be in the stock market, you'll be missing out on any appreciation going on there.

What to do

So what should you do now? Well, if you're in the market for a home, consider not putting down 20% on it. But this doesn't mean you shouldn't be careful in other regards. Be sure you're not buying more home than you can afford. Crunch some numbers to make sure you'll be able to swing your mortgage if your income dips. Make sure you're opting for a sensible mortgage, too -- one that won't triple your interest rate in a few years. Adjustable-rate mortgages can be risky in an environment of rising rates, but if you're pretty sure you'll only live in your new home for a few years, the risk isn't as great.

It can be risky to buy a home with little to nothing down -- especially if you won't live in it for too long. Over the short run, its value could drop, leaving you owing more than it's worth. Over the long run, however, your home's value will likely appreciate.

Make sure you have an emergency fund, too. Bad things happen now and then -- a job loss, a medical emergency, or a leaky roof. You'll want to be able to deal with such things without putting your mortgage payment in jeopardy, and without adding $10,000 to your credit card balance, where it will command interest payments of $2,500 per year at 25% interest.

Get all your financial ducks in a row. Get the mortgage, but also make sure you're investing for your retirement.

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Try any of our investing services free for 30 days. The Motley Fool is Fools writing for Fools.