Save up for a home and put 20% down is common financial advice. Well, I have news for you. This is bad advice. You should buy a home with a low down payment as early as possible. Buying a home with an FHA loan is great if you want a low-interest rate and do not have a lot of cash for a down payment. However, this advice should not be taken at the expense of losing your emergency fund or taking on too large of a monthly payment.
I’ve wanted to share this post for over a year. This will actually be the first of a several part series. Each post will run through a different scenario. An FHA home loan allowed me to buy my first property. Buying a home with an FHA loan may be a great option for you to house hack or buy your first home as well.
Buying a house with less than 20% down
A 20% down payment on a home is known as conventional financing. Anything less than a 20% down payment will require Private Mortgage Insurance (PMI).
Private Mortgage Insurance, or PMI for short, is an extra expense built into the monthly mortgage payment for homebuyers who put less than 20% down. Lenders require borrowers to pay PMI until the borrower has at least 20% equity in the property. PMI was designed to mitigate a lender’s loss if there is foreclosure. Many financial experts recommend avoiding PMI. However, I firmly disagree with this belief.
A borrower may request for a lender to stop charging PMI. The borrower will need to demonstrate there is at least 20% equity in the property which will require a new appraisal. Most borrowers get rid of their PMI from a combination of the home appreciating in value and paying down their loan over time. Generally, refinancing the loan provides the best execution for getting rid of PMI.
In summary, PMI is an added expense to your monthly mortgage. This expense is tax deductible. You can get rid of PMI once you have at least 20% equity in your home. We will walk through several scenarios to show how long it takes to get rid of PMI payments.
Why you shouldn’t wait for 20% down payment
Saving for a 20% down payment takes a lot of time and discipline. Meanwhile, while property values are probably increasing while you are saving up for your down payment. This means you need to save even MORE than you originally thought. Heck, by waiting for a 20% down payment you may have missed the boat in some markets and end up priced out of owning a home.
The earlier you buy a home, the earlier you can start building equity. While renting provides flexibility, you will never see your rent money again. As a homeowner, a portion of your monthly mortgage payment goes towards repaying the loan. This is forced savings.
Waiting to buy a home with a 20% down payment means renting for a longer period of time. This likely means you are saving less since its cheaper to own than rent in most of the country. This means less money is working for you. Your landlord(s) will be happy with you renting longer, but you shouldn’t be.
Buying a home with an FHA loan will get you into homeownership and out of renting earlier.
Buy vs. Rent a Home Debate
In 2017, the median rent in the United States was $1,492 per month for an unfurnished apartment. This means half the country pays more for rent and half the country pays less for rent. Obviously, every city and state will have different rental rates. Some places like New York City and Washington, D.C. have much higher rents. Other places like Greenville, North Carolina have much lower rents.
Often, owning is actually more affordable than renting. This is location dependent. However, we will expand on this in the base case and future scenarios.
According to a recent Zillow report, the national average break-even point for buying a home verse renting a place is 1.97 years (1 year 11 months). This means if you plan to live somewhere for two or more years it makes sense to buy.
The break-even point varies across the country just like rental rates. The Los Angeles market has the highest break-even point; it will take homeowners 3.7 years come out ahead. Meanwhile, Memphis boasts the lowest break-even point. Homeowners in Memphis enjoy a breakeven point of 1.32 years.
FHA loan requirements 2018
Having a limited credit history naturally leads to a lower credit score. Buying a home with an FHA loan is a great option for those with a limited credit history or those with less than stellar credit. The FHA loan credit score minimum is 500. In order to qualify for the minimum down payment of 3.5%, you will need a minimum of a 580 credit score. However, some lenders may require a credit score in the 600-650 range.
Lenders will also look at your income and debts to determine if you can qualify for a loan. Debt to Income ratio or DTI is the metric used by FHA loan underwriters. The FHA debt to income ratio in 2018 is 43%. However, borrowers with good credit may be approved with debt to income ratios as high as 50%.
Several cities and states also offer first time home buyer programs. The first time home buyer programs offer loan options with low or no down payments. Check to see if your city or state offers a program for first time home buyers.
The base case for buying a home with an FHA loan
The Base Case for buying a home with an FHA loan. This scenario will use national average/median data for rents, home prices, rates and other metrics.
According to the National Association of Realtors, the price of existing homes increased by 5.4% annually between 1968 and 2009.
This growth rate accounts for the booms and busts in the real estate market. Our base case will use the 5.4% average growth rate from the past 40 years. Future scenarios will look at a slightly lower growth rate, no growth (flat market), a ‘booming’ market and a ‘bust’ market.
This may be a simplistic way to look at real estate and housing market, however, it provides a general picture of homeownership in the United States. New York City’s real estate reacts differently than Miami. Both of these cities’ real estate experience different variables than Kansas City. No one scenario will work for all markets.
As of March 2017, the US Existing Home Median Sales price was $236,600. Buying a home with an FHA loan requires a 3.5% down payment. A prospective homeowner would need $8,281 for a down payment if they were buying a home with an FHA loan.
The table below breaks out the down payment, loan amount, and monthly mortgage expenses associated with buying a home with an FHA loan. The FHA loan interest rate is lower than a conventional mortgage by 0.25% to 0.50%. This is because of PMI.
For comparison purposes, a prospective homeowner would need $47,320 for a 20% down payment. That’s $39,039 MORE than what it would cost to buy a home with an FHA loan.
Ask yourself, how long would it take you to save an additional $39,000?
|Saving Per Month||# of Months Required||Years|
Depending on your savings rate, it may take you between 3 years and 3 months or over 30 years to save up for a 20% down payment. Buying a home with a low down payment is starting to seem more attractive, right?
That’s because it is. But this is not the only factor to consider. While savings for your 20% down payment, more of your income is going towards rent. While you are renting time is still moving forward. As time passes by, property values are generally appreciating.
Using the same assumption as before, the table below will show how much you may spend on rent while you save up for the down payment. The rent calculation assumes today’s median rent of $1,492/month. This figure does not include any rent increases or account for inflation; you will likely pay more given rents go up over time.
|Saving Per Month||# of Months Required||Years||$ Spent on Rent|
Likewise, property values generally increase over time. Sure, there will be peaks and valleys. However, over a 40 year period, home values increased by 5.4% annually.
Let’s assume you have enough money saved for a 3.5% down payment based on today’s median home price. However, let’s also assume you wanted to put 20% down instead of buying a home with an FHA loan. Today you have $8,281 but you would need $47,320 to avoid PMI. This means you are short $39,000.
Let’s also assume you can save $500/month towards your down payment. At this pace, you will reach $47,320 in savings in about six and a half years. A lofty goal, but not unreasonable if you are dedicated.
But, during the same time property values continued to grow. The median home price is no longer $236,600. While you were saving for the past six years the median home price increased to $324,383. This means a 20% down payment is now $64,877. You are now $25,838 short of having a conventional downpayment and avoiding PMI.
The table below shows how much more you’ll need to save based on your savings rate:
|Saving Per Month||# of Months Required||Years||New Home price||New 20% Down Payment||Gap|
Now, let’s take a look at what would have happened if you bought a home today instead of waiting for a 20% Down payment. The table below shows how much principal, interest, PMI, taxes, and insurance were paid for each of the first three years.
|Year||Total P&I||Interest||Principal||PMI||RE Tax||Insurance||Total||Loan Balance||Property Value||LTV|
The table also shows the loan balance decreased while the property value increased over time. Based on this scenario, the homeowner would achieve 20% equity somewhere between years two and three. This would allow them to refinance their loan and get rid of PMI which would result in monthly savings of $133.
At the end of year three, the homeowner would have $61,278 of equity in their home. This includes $8,281 from their down payment, $40,436 from the property appreciating in value over three years, and $12,561 from paying down their mortgage
|Property Value @ the end of Year 3||$277,037|
|Original Property Value||$236,600|
|Equity From Appreciation||$40,437|
|Original Loan Amount||$228,319|
|Loan Amount Year 3||$215,759|
|Equity from Principal Reduction||$12,560|
|Total Equity @ the end of Year 3||$61,278|
After three years the homeowner would have paid their loan down to $215,759 and the property would be worth $277,037. The homeowner’s loan to value (LTV) is now 77.9%. This means the homeowner now qualifies for a conventional loan and can refinance to get rid of their monthly PMI payments. Heck, the owner could even refinance the closing costs into their loan and pay no out of pocket costs.
In this scenario, buying a home with an FHA loan now would have been better than renting.
The renter would have spent $1,488 more on rent over three years than the homeowner spent for their mortgage payment (principal, interest, taxes, insurance, and PMI). The renter also missed out on over $40,000 in equity through appreciation. Additionally, the renter will never see their rent money again. The homeowner was able to pocket $12,560 by paying down their mortgage. After three years of savings, the renter still may not be in a position to make a 20% down payment on a home.
Buying a home with an FHA loan or a low down payment has many benefits. In the future, we will continue to explore other scenarios.
Future posts will include the following scenarios:
Slightly more conservative case: Modest (less) appreciation
The Flat Scenario: No inflation
Booming market: The Austin Housing Market
Making Extra Payments
House Hacking Scenario
House Hacking and Extra Payments
The Bust Case: When the housing market corrects