(8/14/2008) If you want to minimize your losses in the declining real-estate markets, putting in 20% down gives in a better deal than putting in only 10% down.
Educational article by Sam Mishra, MBA (MIT Sloan)
What is better? 20% down payment, or 10% down, or zero down? If you have been reading my earlier articles so far, you probably know that I am a strong advocate of putting in a large down payment, so that you have some equity in the house. However, let's indulge in some simple sixth grade math to see if making a large down, as opposed to a small one, serves one well in these times of credit crunches, decimated home prices, and rising mortgage interest rates.
Suppose John bought a home worth $600,000 by paying 20% down. For purposes of this calculation, let us ignore interest rates, real-estate agent commissions, property taxes, earth (quake) / air / fire insurance premiums, etc. Since home prices are declining nationwide, let's assume that down the line, he sells the home for $550,000, since prices are now going down... This is the first scenario. In a second scenario, let's assume Jill buys a house for $600,000 by paying only 10% down; and is later forced to sell it for the same lower price of $550,000 as well. Now let's calculate who comes out ahead.
First scenario:
Initial investment of John = 20% of 600,000 = 120,000 USD
Money owed to the bank = 600,000 - 120,000 = 480,000 USD
House is sold for $550,000.
Money returned to the bank = 480,000 USD (unless you want to be foreclosed, you have to return to the bank what you owe!)
Money left in the pocket = 550,000 - 480,000 = 70,000 USD.
So, John started with an initial investment of $120,000, which is now worth only $70,000.
Net loss = 120,000 - 70,000 = 50,000 USD.
Net loss as a percentage of invested capital = 50,000 ÷ 120,000 = 41.66%
Second Scenario:
Initial investment of Jill = 10% of 600,000 = 60,000 USD
Money owed to the bank = 600,000 - 60,000 = 540,000 USD
House is sold for $550,000.
Money returned to the bank = 540,000 USD.
Money left in the pocket = 550,000 - 540,000 = 10,000 USD.
So, Jill's initial investment of $60,000 is now worth $10,000.
Net loss = 60,000 - 10,000 = 50,000 USD.
Net loss as a percentage of invested capital = 50,000 / 60,000 = 83.33%
To conclude, whereas John incurred only 41.66% loss by putting in
20% down, Jill incurred twice as much, or 83.33% in losses; because she
put in only 10% down. In other words, putting in a higher down is good
insurance against deep losses in today's declining real-estate markets.
Do you disagree with me? I will be delighted to receive your
feedback. Please use the feedback form below for the same. Thank you.
Disclaimer: This is an educational article, which makes certain recommendations regarding home purchase for first-time home buyers, who have been ripped off by everyone from unscrupulous lenders to greedy home-builders / real-estate agents. However, recommendation is not advice. What you invest in is at your own risk. Please read our Terms of Service.
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