One question we get a lot here on the team is how much money should someone put down on their home.
As little as possible.
This may seem counter-intuitive and low down-payments will not always be the best option for all situations, but one of the perks to investing in real estate is your ability to leverage “Other People’s Money” (OPM).
This gives real estate investing a large advantage over other forms of investing for a couple of reasons:
- It allows you to mitigate most of the financial risk surrounding your investment.
This is because by reducing your initial capital investment, if the market were to cash and you needed to sell the home at a loss, or even allow it to go into foreclosure, you will have only lost 5% of the initial purchase price of the home rather than 20%. On a $200,000 home, this is the difference between losing $10,000 in capital vs $40,000.
- A low down-payment also allows you to diversify by letting you use your liquidity to invest in other opportunities, or even purchase multiple properties.
Overall, there are a lot of other investments out there than can produce larger returns than owner occupied real-estate. Experts often cite that the Stock Market produces 12% returns year over year; this is better than almost any other investment available to the public. Using the ‘$200,000 home with 5% vs 20% down’ example again. We will use two people who both have $40,000 to invest.
The person who puts 20% down takes all $40,000 and puts it down on a home. Real estate is known as a “non-liquid asset” meaning that money is locked into the asset and is not retrievable.
The person who puts down just 5% spends just $10,000 on their down payment and now has a wide range of options for what they can do to invest their additional $30,000. One option is to purchase an additional $200,000 to be used as a rental, and then use the remaining money to invest into the stock market. Most lenders require 10% down on second homes, so the purchaser could put down $20,000 on another $200,000 home which gives them the opportunity to collect rental income, and still have an additional $10,000 left over to invest into the stock market.
Let’s break these two examples down:
In 30 years the person who put down the 20% has now paid off their $200,000 home. At an appreciation of 4%/year compounding, their home is now worth $648,679. Not a bad return.
On the other hand, the person who put just 5% down also owns the same $648,679 home that is also completely paid off, but remember this person also bought another $200,000 home that is also now worth $648,679, and they also put $10,000 into the stock market: assuming a conservative return of 8% compounding yearly with $0 additional contribution, that Stock Market investment is now worth $100,626. The two homes and stock portfolio now have a net worth of $1,397,984.
Both of our investors had $40,000 in liquidity to invest. The big difference is how that money was diversified, and as you can see, some simple choices at the start of your investment career can have HUGE impacts on long-term returns.
Please note that a low down-payment strategy ONLY works when using your additional funds to invest. Putting $10,000 down on your home, so you can buy a new truck for cash is a bad investment, and you would have been better off putting down the additional funds on your home to avoid paying mortgage insurance.
This strategy also only works if your goal is long term investing. If you are retiring, and simply don’t want a mortgage, this is not the plan for you.
This blog post did originally acknowledge the difference in monthly payment when putting down more money versus less, but in the interest of simplicity I have removed that portion. Believe me, it still pays to put down less money than more even when factoring the higher monthly payment for those people who put down less than 20%. IF you would like to discuss, comment below, or even feel free to email me directly.