Before I tackle the current reality of today’s seller’s market, let’s start with a little context as to where the standard 20% down payment originated. Borrowers securing a mortgage to buy a property with less than a 20% down payment are almost always required to pay a significantly higher interest rate or secure Private Mortgage Insurance (PMI). PMI is an expensive insurance policy that protects the lender (not the buyer!) in case of a loan default. These policies could cost as much as 1% of the loan value or $10,000 a year on a $1M loan. To avoid this expensive scenario, the industry standard was to advise clients to save their money until they could afford a 20% down payment.
In today’s competitive market that dynamic is changing, and I am seeing new strategies for putting together a winning bid. I’ve found that the industry standard is for listing agents and sellers to now be looking for 30% down as a minimum and 40%+ as optimum. They’re looking for these types of numbers for a couple of reasons. First, it shows financial strength which in their mind equals a higher probability that the deal will close without any issues. Having a sale fall through can generate a negative stigma to the property and cost the seller hard dollars as well as significant transaction delays. Buyers with larger down payments appear better positioned to be able to complete the transaction with extra cash for all of the closing costs, insurance, etc.
The second and a more important reason for a larger down payment is that it shows that you’ll have the financial resources in case the house does not appraise at your purchase price. Let’s walk through an example. Say you’re looking at a $1.5M property and the bank is willing to give you a loan up to $1.2M. You “only” have $300K in the bank for the down payment (believe me, I know how ridiculous that sounds). If you were to bid on that $1.5M property, your assumption would be that you’d use your $300K as a 20% down payment, paying the rest with the $1.2M loan. But, when you take out a loan, the bank is required to send out an independent appraiser to check the value of the asset on which they are basing the loan. They want to make sure that their investment is sound because if the buyer forecloses, the bank has to sell the property to recoup their loss. In today’s market, housing prices are rising so rapidly that appraisers sometimes can’t justify the purchase price as a realistic value for the home. It doesn’t happen often, but it does happen. So, back to our example, if the home appraisal comes back at $1.4M instead of $1.5M, the bank will only loan you 80% of 1.4M which would be $1.12M, meaning that you would then need to produce $380K to close the deal. Not all buyers will have an extra $80K available beyond their $300K down payment in order to complete the transaction. As a result, sellers get nervous when they see the potential for this scenario with 20% down bids.
This may change as the housing market cools, but today the best way to put together a winning bid is to bump up the down payment percentage to protect against the possibility of appraisal risk, and of course, to work with a reputable lender and agent. If you have any questions, I’m happy to talk through this with you in more detail and give you some examples of what I’ve seen recently in the market.
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Here's to your new home!
Cindy
Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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