A question every home buyer should ask is: How much should my down payment be? I am going to go over some of the risks and benefits of a big house down payment. In this article, I am going to be answering the following questions:
- Should I put down minimum down payment?
- Opportunity costs of a down payment?
- Which down payment option will make be wealthier over time?
Should I put the minimum down payment?
In Canada, it is likely you are going to be taking out a mortgage to buy your house. A mortgage is money from a bank or other financial institution to help you fund your home. In Canada, the mortgagor (lender) usually requires you to front some of the money to help with the housing cost. This amount is a minimum of 5%. For a home price of $400,000, you will need to put down at least $20,000 to help with the cost. That means your mortgage will be $380,000. You might now be thinking, great, I’ll simply pay the minimum possible, and go about my day! But one factor to consider is what your monthly cost will be. There are several factors that go into this.
- Down Payment Amount
- Default Insurance
- Mortgage Timeline
The higher your down payment, the lower your monthly costs. The monthly amount does vary depending on the down payment, so there is a spectrum. In fact, the higher your down payment, the less interest you will actually spend, in total, on your house! For example, consider Table 1 below:
For a home price of $400,000, someone putting down 5% will pay more per month than someone putting down 20%. This is for several reasons:
- A higher amount borrowed overall will increase the payment.
- Any down payment less than 20% requires default insurance. The Royal Bank of Canada created a document to help client's understand this, but the rationale is this; Putting down less of a down payment will have higher debt ratios, making it riskier for financial institutions to lend. The default insurance protects the bank from such events. In this example, a 5% down payment requires a 4% default insurance premium. So, the amount you will actually be taking out will be $380,000 (price – down payment) + 4% of $380,000, or $15,200. Hence why the total mortgage amount is $395,200 in the chart above instead of $380,000.
- Mortgage term. In Canada, down payments less than 20% can be no more than 25 years. This was a policy change many years ago, and may change in the future. Shorter terms will increase the mortgage payment. Those putting down 20% can have a mortgage term of 30 years, decreasing their monthly payment.
In totality, the mortgage payments are designed in such a way to pay down your mortgage + interest over time. When you put down a lower down payment, you end up spending more money on interest. See Table 2 below:
While in both cases, the interest rate is 2%, that 2% is applied every year there is a mortgage balance. At the end of your term, the person putting down 5% will be paying more interest than someone putting down 20%. Banks love those who put down 5%, but they make up to 4X more money from those individuals.
Okay, so should you then put down more than 5% or even 20% to avoid such high interest costs? Maybe, but that decision to be based on whether you can afford the monthly payment. If you can afford to put down both 5% and 20%, you are one of the lucky ones to face opportunity costs. This is important because if you end up making a bigger down payment, you forego using those additional funds for other opportunities. Other opportunities could be buying a car, going on vacation, and/or investing. The benefit you receive, on the other hand, is a lower monthly cost of carrying a mortgage and less total interest costs as I have shown above. You will need to weight the pros and cons yourself, but I will show you an example of this.
Opportunity cost of a down payment
Every dollar you spend on something you forgo spending that dollar on something else. This is exactly the situation you’ll find yourself in when you’re deciding whether to put down 5% or 20% on a house. Sticking to the example above, suppose you can afford a 20% down payment. You can obviously also afford a 5% down payment too, but you are weighing the pros and cons of doing either.
If you decide to put 5% down, your monthly payment is $1,675 per month, but, you have an additional $60,000 to use for other opportunities. If you decide to put down 20%, you spend an additional $60,000, but you get a reduced monthly payment to $1,183. Another way to think about this is as follows: by putting down 20%, you are spending $60,000 today, and getting $492 every month (difference between the monthly payments of 5% & 20% down payment). By putting down 5%, you get $60,000 today to do with it what you please. In terms of maximizing wealth over time, what you do with the $60,000 or $492 every month matters a lot.
1) Opportunity cost of Saving the benefit
In this example, suppose that each person just saved their respective amounts. The 5% person saves their $60,000 and while the 20% down saves their $492 each month. Assuming that simple saving earns you no money, Chart 1 below shows what happens after 25 years.
Clearly the person who put down 20% will end up with more than double the savings after 25 years. In fact, after about 10 years, the 20% down person reaches the $60,000 that the 5% person had. Now here is something else to consider. What not 30 years? The reason is because the 5% down person has now paid off their mortgage. They can now start to save the amount they would have otherwise been using for their mortgage. Chart 2 below shows what happens after 30 years.
Even still, the person with 20% down will have a greater overall savings after 30 years. This result is the same no matter what the mortgage rate is.
2) Opportunity cost of Investing the benefit
Instead of saving the benefit, you can invest the benefit. This is one of the better best ways to compare these two situations. The 5% down will invest $60,000 one time, while the 20% down will invest $492 every month. I will give an example of two scenarios. If the rate of return on investments is 7% per year, Chart 3 below shows what happens to your investment wealth over 25 years.
Something interesting happens here. An investment of $60,000 is higher at first, but grows at a much slower rate overall than a $492 monthly investment. At the end of 25 years, the 5% down person ends up with $341,533, vs the 20% down person, who ends up with $398,790. This is 17% higher overall. Now you might be thinking, this is great, I am going to put down 20%, reinvest the difference in monthly payments, and voila!
Not so fast, I’ve neglected to show you what happens after 25 years. In fact, once the 5% down person has paid off their home in 25 years, the 20% down still has 5 more years of mortgage payments! This is important because after 25 years the 5% down person frees up their monthly payment, which can now be used for other opportunities such as investments. If I assume that the 5% down person starts to invest their $1,683 into the same investment, similar to the savings scenario, while the 20% down person continues to invest the $492, you will see something different. Chart 4 below shows this.
After 25 years, the 5% person sees their wealth start to watch up with the 20% person. In fact, after 30 years the two actually end up with more or less the same wealth ($601,000 for 5%, $604,000 for 20%).
This is obviously a very simple example and is based on many assumptions that may not hold true in the long term such as: Investment Returns are always 7% per year, interest rates are always 2%, and that individuals will always reinvest their savings. The first two are probably impossible, and the third would depend on the will and dedication of the individual. The outcomes are sensitive to the assumptions. For example, changing the mortgage interest rate from 2% to 3% makes the person putting 5% down worse off. See Chart 5 below:
On the other hand, on Chart 6, changing only the investment return to 8% benefits the person who put down 5%.
Which down payment option will make me wealthier in the long run?
As you have seen in the previous examples, the answer to this depends on the assumptions. I have mapped out how different combinations of investment returns and interest rates can impact the differences between someone’s ending wealth; see Chart 7. Here’s how to read this chart. The points above the line are combinations of investment returns and interest rates that make it worthwhile to put down 5% over 20%. The size of the bubble indicates a greater benefit for that camp. Points below the line are combinations below the line make it more worthwhile to put down 20%.
This simple yet powerful chart shows roughly how much more or less wealthy you can end up being in different environments. The best time to put down 5% is when interest rates are low and when you expect investment rates to be high. This is partly because putting down only 5% increases overall interest costs, so you would stand to benefit from lower rates. Today, interest rates for mortgages are around 2.3%, which is very low compared to historical standards. In low interest rate, high investment return environments, 5% makes more sense. Whereas when interest rates are higher, and investment returns are lower, putting down 20% makes more sense.
At the end of the day, it has to come down to what you are comfortable with. But I have created a general guideline if you’re still unsure what to do from here. Consider this simple step-by-step:
- Find out what your mortgage interest rate will be. Banks can usually lock in a rate for you for 90 days.
- Add 4.5% to the mortgage rate
- If you think the market will return more than “Mortgage Interest Rate + 4.5%”, putting down 5% may make more sense in the long run, otherwise put down 20%
That’s key here, only you can decide how to formulate your expectations for future investment returns. Historical returns are simply a guide, and not a prediction. For example, if you are quoted an interest rate of 2.3%, add 4.5% and ask yourself if you think your investment return will be higher or lower than 7.8%, on average, over the next 30 years. In Canada, the average return for the TSX Composite has been 6.29% from November 1, 1991 to November 1, 2021.
In conclusion, purchasing a home is a major life decision and you start to think about the costs and opportunity costs of making this decision. In this article I presented a case of two home buyers choosing whether to put down 5% or 20% as a down payment on their home. If you simply intend to save the extra money from not making the larger down payment, then the long-term benefit from putting down a larger down payment will be the better choice. If you are investing the benefit, the best answer isn’t a simple one. While interest rates determine what your ultimate costs will be, opportunity costs can determine how much wealth you will end up with when you pay off your mortgage.
To reap the benefits of accepting a lower down payment of say 5%, you must have the willingness to invest the difference between that and what you would have spend on a 20% down payment. Even if you do have the will to do this, there is never a guarantee that you will end up with more wealth. Markets, Interest Rates, and life circumstances can change in a moment, let alone 30 years. Nothing is guaranteed, but I would encourage you to use this article as a guidepost when making your down payment decision. Remember, this is not financial, investment, tax, or mortgage advice. You should always speak to the appropriate professional when making such big decisions.
If you found this article helpful in figuring out how much you should put down on your first or next home, please have a look at some of our other articles! Best of luck in the home buying process!