We are all familiar with the famous 1897 letter to the editor from an 8-year-old girl and the thoughtful response from the New York Sun.
DEAR EDITOR: I am eight years old. Some of my little friends say there is no Santa Claus. Papa says, “If you see it in THE SUN it’s so.” Please tell me the truth, is there a Santa Claus?
– Virginia O’Hanlon
115 West Ninety Fifth Street
VIRGINIA, your little friends are wrong. They have been affected by the skepticism of a skeptical age. They do not believe except they see…. Yes, VIRGINIA, there is a Santa Claus.
Sometimes I think the general perception of prospective homebuyers, especially first-time homebuyers, reflects this same type of skepticism. After all, how can a homebuyer believe in the dream of homeownership considering how long it takes to save for a down payment?
Recently, Forbes published an article that referred to the most significant challenge to homeownership being the accumulation of a 20% down payment. It’s hard to disagree with this point. Consider the example used in the article, where $36,500 represented the average 20% down payment in the country, equivalent to an average purchase price of $182,500. Since the US average savings rate is approximately 5% and the average household income is roughly $55,000, the average household would be saving $229 per month toward a down payment. At that rate, it would take more than 13 years to accumulate a 20% down payment (if home prices don’t increase over time). That is a significant challenge!
What I can’t agree with is the author’s assertion that “If you’re shy of this amount, you’ll face higher monthly mortgage payments and have to shell out for mortgage insurance, which makes the whole home-buying thing that much more expensive in the end.” See the full article.
I would like to challenge that notion and, in fact, make the case that waiting until they have saved the full 20% down may cost the borrowers more in the long run.
Let’s look at our average household again. If the borrowers’ goal was to put 5% down on that same house, they’d only need to save for a little more than 3 years. Their monthly mortgage payment, before real estate taxes and insurance, would be approximately $827, assuming a 30-year, fixed-rate mortgage with an interest rate of 4% and a 720 credit score. Taxes and insurance would add around $200 to the monthly mortgage payment. Add another $90 for monthly, borrower-paid mortgage insurance for standard Agency coverage, and the total monthly payment comes to $1,117. In its annual housing report “Out of Reach,” published earlier this year, the National Low Income Housing Coalition found that the US average cost to rent a two-bedroom unit was $1,006. On the surface it would seem the author’s assertion is accurate, but let’s take a closer look.
As stated above, if the prospective homeowners decided to wait and save a 20% down payment, it would take them an additional 10 years to accumulate the required amount. Of course, that assumes home prices remain unchanged over that time frame. A more likely scenario, based upon current economic forecasts, is that home values will appreciate approximately 4% annually. This means in 10 years the $182,500 home is now valued at $270,000 and a 20% down payment would be $54,000. At that point it could cost 50% more to buy the home, and as a result, the borrowers would need to save an additional $17,500.
With only a 5% down payment and buying sooner than later, the borrowers would benefit from the price appreciation in the intervening years and build equity with every payment. So even after mortgage insurance is factored in, the average household, in this example, would benefit from being able to purchase the home of their dreams earlier and at a lower price.
Which brings me to a final point: Private mortgage insurance may be cancelled under several circumstances; one of them being the home’s value appreciates to the point where borrower equity reaches 20%. In our example, with just 4% annual home price appreciation, the borrowers may be able to cancel the mortgage insurance in less than 4 years . In any event, when mortgage insurance is cancelled, the monthly mortgage payment is reduced by that amount — and mortgage insurance becomes a non-issue.
Does mortgage insurance have a cost? Yes. Do the benefits of financing with it to purchase sooner outweigh its cost? In many circumstances, the answer is yes. I would further submit that mortgage insurance improves the financial stability of a household, as overall housing costs drop (as rent payments most likely will continue to increase); therefore, more household wealth is created both in terms of cash and equity.Tags: Down Payment, housing, Housing Market, Mortgage Education, Mortgage Industry, Mortgage Insurance