During the homebuying process, the largest up-front expense you can expect to pay is going to be your down payment.
Typically, the recommended amount people are told to save for their down payment is 20 per cent of the final purchase price of the home – with additional funds set aside for other fees such as closing costs and legal fees. However, that 20 per cent recommendation is often just that, a recommendation. So that bares the question, is a 20 per cent down payment always necessary?
Before looking at the bigger picture it is important to acknowledge that the amount of money required for a down payment will fluctuate with your specific financial circumstances and the requirements set by the lender when determining your interest rates and loan amount. So, it is important to save as much as possible for your down payment in order to ensure you qualify for the best mortgage available.
However, there are advantages to both using a 20 per cent down payment, and paying less. So, let's take a look at the advantages of both options.
Table of Contents - Is a 20% Down Payment Always Necessary?
Understanding Loan-to-Value Ratios
The amount of money you have saved for your down payment plays a key role in determining your loan-to-value ratio (LTV). This ratio is calculated by taking the total loan amount provided to you by the lender and dividing it by the appraised value of the property. This ratio is used in order to figure out the risk associated with a mortgage loan to help set the pricing and eligibility for different mortgage products.
For example, a lender may offer a rate of 2.30 per cent on a five-year variable rate mortgage. However, in order to qualify for this rate, the LTV ratio would need to be no greater than 85 per cent. Under this circumstance, you would have to put a minimum of 15 per cent down but would not necessarily require the full recommended 20 per cent. To qualify for a loan with this requirement when buying a home valued at $400,000, you would need a minimum of $60,000 saved for your down payment and a loan worth $340,000 to meet the 85 per cent LTV.
Move-In and Living Expenses
Another reason you may not wish to put the full 20 per cent down for your mortgage is in order to ensure you have enough money to cover any move-in and living expenses that you will have immediately after your purchase.
Many new homeowners make the mistake of spending every penny they have saved on their home and forget to save for costs such as movers and new furniture. After all, it would be a poor experience to spend thousands of dollars on a home only to find out you cannot afford a couch or comfortable bed frame to enjoy the benefits of their purchase as well as lacking the funds to go out and
So, if you do not already have furniture or separate funds saved to cover furnishing and the cost of moving it, it may be worth it for you to reduce your down payment amount so that you still have funds remaining afterwards.
Maintaining an Emergency Fund
Unexpected financial emergencies are an unfortunate fact of life. So, in order to adequately prepare for an emergency, it is recommended that you save a few months' worth of your earnings in order to cover circumstances such as sudden unemployment, urgent home repair or expensive medical emergencies.
However, if you only have enough money saved to pay the 20 per cent down payment and lack further funds and putting that amount down would wipe out your savings account, it may not be recommended that you pay the full amount. Otherwise, you run the risk of defaulting on your mortgage almost immediately in the event of an emergency.
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The Benefits of a Larger Down Payment
While a full 20 per cent down payment is not always needed, it is recommended that you put as much down as you can afford to when buying a home within reason. In fact, some lenders offer mortgage products available to buyers who put down more than 20 per cent of the purchase price of the home.
Let’s take a look at the advantages of supplying a larger down payment of 20 per cent or more.
Since you have paid more money up front, you are able to take a much smaller loan from your lender in order to buy your home. This helps you keep your debt ratios low and can help you qualify for other loans and lines of credit much easier in the future.
Reduced Insurance Premiums
Mortgage insurance is designed to help cover the risk of borrowers defaulting on their loans. Since the risk associated with higher LTV ratios is higher, people who pay less up front end up spending more on insurance. So, by increasing your down payment you are reducing the amount of money you are set to spend on mortgage insurance.
By putting more money down up front, the estimated risk associated with your loan will be considerably lower. This will allow you to qualify for lower interest rates and spend less money overall paying back your mortgage. This can save you thousands of dollars over the course of your mortgage repayment
Due to spending more money on your down payment, you have a higher chance of qualifying for a shorter amortization period. This will raise you individually monthly payments, but in return will help you save money overall by reducing the amount you pay in interest over the entire lifetime of your mortgage.
Of course, every mortgage is unique due to each borrower having their own distinct financial profiles. So, if you are ready to buy a home or are getting ready to begin searching, contact us at LendCity and we will happily help you get started with a pre-approval with the ideal lender for your financial needs. To learn more, you can give us a call at 519-960-0370 and speak with a member of our team, or you can visit us online at LendCity.ca
5% vs 20% Down Payment on a House
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