The aftermath of the housing crisis brought many lessons with it. Perhaps the most obvious lesson was to carefully purchase a home within one’s budget and not overlook details in the terms of the loan. But another lesson seemed to defy the common belief that homes will always increase in value. We learned that housing prices, like anything else, can drop very quickly. Putting down a significant down payment of 20 percent can be a good hedge against a drop in home values.
While home prices have been slowly rising, over 6.4 million home buyers in the U.S. were still underwater with their mortgages as of the third quarter of 2013. These buyers are likely victims of the housing bubble which collapsed in 2008.
In many areas until that time, home values rapidly increased, but with historically low interest rates and a low threshold and few checks to qualify for a mortgage, buyers flocked to the market, often putting little down on high-ticket mortgages. When home values plummeted, millions were underwater with their mortgages, meaning they owed far more than what the homes were worth, sometimes by as much as several $100,000.
Traditionally, most people put down about 3 to 5 percent as a down payment on their home purchase. This approach, while common, proved to be dangerous over the course of the housing bubble, as homes dropped by as much as 10 to 20 percent. Even with 10 percent down, this is a steep loss into negative territory, especially for new mortgage holders who are paying more in interest than principal. A 6 percent loss on a mortgage taken out two or three years before with 5 percent down can easily go underwater if fees and repair or other costs were financed into the mortgage or the interest rate is high.
There are other advantages with a bigger amount of cash for a down payment. More stringent requirements from lenders and mortgage insurance backers such as the Federal Housing Authority means buyers who come in with a higher down payment are more likely to get approved for a loan or may qualify for a better rate. It will also make it easier to get a home equity loan down the road if needed.
Taking the time to save 20 percent also puts a family into good practices with saving and more prepared to make steady mortgage payments. Once you’ve been living on a strict budget for a while, it is easier to continue to do so after a home purchase, when other costs may come up, like replacing appliances, repairs, or redecorating.
In 2013, the S&P Case-Schiller 20-city home price index showed a rise of over 13 percent in home values. This helped to pull many buyers out of their underwater status, but the overall trend may not hold up in all neighborhoods. In some cities, many neighborhoods are flooded with foreclosure properties, and the property values of surrounding homes will continue to decline unless enough new buyers decide to come in and live in the homes, creating valuable communities. With a higher down payment, the risks associated with ending up in one of these neighborhoods is lower because the homeowner won’t need to ask as much to sell and is less likely to be locked into the home if they want to leave.
While many factors affect sound housing purchases, a large down payment can provide a huge safety net in the event housing prices fall and the homeowner decides it is time to move. Research wisely, understand your credit score, learn about mortgage rates, and save up for a sizable down payment.
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Shirley is a staff writer for MyBankTracker who covers personal finance trends, money habits, mortgages and foreclosures.