Whether or not you’re in the market for a house right now, you’re probably feeling a bit flooded with stories of soaring home prices, seller’s markets, and housing shortages. So, let’s not talk about that. Instead, let’s consider how to pay for a house, specifically the down payment. Few of us pay for a home in cash, though I think it would be a nice option to have. So, if we have to finance a house what should we consider?
How Much Down Payment is Enough?
The average home sales price in the U.S. is at an all-time high, so let’s assume you’re spending $400K on a home. An FHA (Federal Housing Administration) loan usually requires at least 3.5%. A conventional (not backed by a government program) loan usually requires 20% or you have to pay PMI (private mortgage insurance). A VA loan doesn’t require a down payment at all. Of course, the VA loan requires a funding fee of 1.4% to 3.6% unless you qualify for a waiver—usually based on disability compensation.
So, for our $400K home we’re looking at $5,600 to $80,000 just to get started with a loan. Now, the VA funding fee can be rolled into the mortgage, so that’s usually not a barrier for our tribe. But it’s possible that between fees and the interest rate, an FHA or conventional loan might be less expensive, so you’ll want your lender or mortgage broker to pull that thread all the way before you decide.
If you have the money for a down payment, you’ll want to consider whether it’s most effective for your financial plan to deploy that cash for a down payment, or hold shots to target other groups.
Reasons to make a sizeable down payment:
Smaller monthly payment. The more you put down, the lower your interest rate (usually) and the lower your mortgage payment. The math might say you can afford the payment, but if you’ll feel “house poor” because your mortgage gobbles up most of your paycheck, boosting your down payment can create more slack in the budget over the life of your loan. Most financial planners recommend that you spend no more than 28% of your gross income on a mortgage and no more that 36% on debt payments in total. Dave Ramsey recommends paying no more than 25% of take-home pay in order to free up cash for other goals. The right amount will be unique to your family, but it’s a number you should put a lot of thought into.
Instant Equity. If the home is worth $400K and you only owe $320K because you put 20% down, you have some shock absorption built in. If you need a home equity loan, you have equity to borrow against. If the market tanks and you have to PCS and sell, you’re less likely to have to write a check just to escape the house. That may sound like a remote possibility, but a chat with any of the silverbacks who survived the 2007-2009 housing market will assure that it’s a thing…
Focus on What Matters. If your family might use those dollars for less important missions, you might use that down payment as a commitment device to prevent leakage. $80,000 in discretionary purchases probably won’t buy you as much financial freedom as home equity and a smaller payment.
Rent-ability. If you do need to PCS and rent the home out, a large down payment and smaller mortgage give you the ability to rent the home out at more competitive rates. If a recession is forcing rental rates down, you’re less likely to have negative cashflow each month just to keep renters in the home.
Reasons NOT to make a sizable down payment:
Interest rate arbitrage. If your mortgage interest rate is 2.5% and you believe you can (AND WILL!) invest the down payment funds at, say 10%, then you can earn 7.5% more by investing the money instead. More on this below.**
Other financial goals. If you also need to pay for a new car, college, or even major repair to the new home, each of which usually carries a higher interest rate, borrowing more for a home can make mathematical sense.
Short ownership period. While this is not a gamble I would take, (again, talk to the Silverbacks…) if you think you can sell the home in a short time and make a capital gain after transaction costs and (potential) taxes if you own the home less than 2 years, then locking up your cash in a down payment might not be compatible with your goals.
Mortgage interest tax deduction. While only 10% of taxpayers can still itemize their deductions, which is the ONLY way to take tax-advantage of mortgage interest on a primary residence, the larger your interest payment, the better chance you can deduct the interest. Let’s assume you finance the whole $400K, and you pay the maximum $10,000 cap for state and local taxes, then your interest rate would need to be about 4%, paying $15,100 to itemize deductions in 2021.
**Interest rate arbitrage can be a dangerous game. Even if your down payment is off earning a rate of return greater than your mortgage interest rate, you can quickly feel house-poor because your mortgage payment crowds out your other budget priorities. Whatever your alternate investment for the down payment is, it probably has tax consequences that you’ll need to consider, whereas your mortgage interest may be deductible.
If you invest the theoretical $80K down payment and actually earn 10% for a period of time, you’ll still have to decide when and how to pay the taxes on those gains in order to take advantage of the gains.
Additionally, you should consider whether lump sum or dollar cost averaging suits your investment needs better. I.e., if you invest your down payment rather than put it on a house, you’re likely investing it in a lump sum. You’re definitely forgoing the opportunity to dollar-cost-average (DCA) the extra dollars that you’re now putting into your mortgage payment.
Which ever path you choose, make sure it’s the best for your family. More than a few industries thrive on getting you to choose the biggest house with the biggest mortgage, but the reality is that people own a home for 8 years on average, not the 15 or 30-year mortgage term. Is it really a forever home? If not, is elephantiasis of the mortgage a win?
Taxes and Down Payments
Now that you’ve decided how much down payment to lay out, where will the money come from and what are the tax effects? Many of us save in a taxable brokerage account over several assignments until we meet merge criteria with a home purchase. If you’ve been doing that since March of 2009, chances are that you’ve seen some great growth of your investment. But, is liquidating the whole account to pay the down payment a good call?
Let’s assume that you’re married filing jointly, taking the standard deduction and your adjusted gross income from wages before selling any investments is $170K. You sell $80K of your mutual fund/stock/ETF investment in order to fund the down payment, but the following year, your tax bill causes your head to explode—what happened?
When selling your investment, you incur capital gains tax on the gain above the basis—generally your purchase price plus the value of reinvested dividends. If you held the investment for a year and a day or longer, then in 2021 you’ll pay long-term capital gains (LTCG) rates of:
0% if your taxable income is under $80,800
15% if your taxable income is $80,801 to $501,600 (most of us)
20% if it’s above $501,601
Let’s say you your basis is $20K, but all shares have been held over a year. Your LTCG will be $60K. At tax time, line 7 of your form 1040 will say $60K and line 11, your adjusted gross income (AGI) will be $230K. Here’s how the tax effects shake out:
Pay $9,000 (15%) on the $60K LTCG from selling investments to fund the down payment.
Pay $23,375 on the $170K of ordinary income (Check these numbers with Internet access)
Taxable Income is $204,900 which, among other effects puts you squarely in the Roth IRA phaseout range of $198K-$208K. (2021)
So, not only did that investment sale come with a $9,000 bill, it effectively forced you to do a Backdoor Roth IRA this year.
My apologies if you were told there would be no math… but the takeaway is that while you probably expected to pay capital gains taxes on the “down payment sale” you may not have expected to be nudged out of “Front door” Roth IRA eligibility because the capital gains increased your AGI. To pile on the bad news, you’ll also lose some or all eligibility for other tax benefits such as the American Opportunity Tax Credit and the Student Loan Interest Deduction.
If you weren’t planning on these tax effects, you may find yourself wishing you’d funded the down payment another way, so let’s look at some of those options:
Save using cash, rather than equities. While the term “high yield” has become a euphemism for “not high yield,” a high yield savings account, CD, or money market account is at least going to provide a safe (FDIC insured up to $250K) place to store, if not grow, your down payment fund. If your purchase is within 5 years, this is generally smart so that your funds aren’t facing so much market risk.
Use a ladder. “Laddering” refers to the investment strategy of layering your investments such that you liquidate a portion at regular intervals. g., rather than selling all $80K of your down payment fund in a single year, spread it out over a few years. While this limits the time for compounding of some of the dollars, it reduces market risk and potentially taxes.
Borrow it all. What? Earlier, I just argued against smaller down payments, but what if you were planning on a 100% down payment? If you liquidate a $400K investment with a low basis, you could easily find yourself paying an ugly tax bill that you might not have the cash to afford. You could “ladder” your investment sales over a small number of years, say 6 to 9, recognizing smaller gains each year, potentially paying deductible interest if you can itemize, and still zapping out the mortgage quickly. This would be a tough strategy to optimize, but it could work for some.
Targeted Investment Sales. If you’ve been investing periodically over the years, you probably have a different basis for each lot of your purchases. Many custodians allow you to track the basis by lot since 2012. You might be able to sell the highest basis shares, but you’ll want to be very deliberate in choosing lots of shares to sell.
Ultimately, how you conjure up your down payment deserves a lot of thought, because it won’t be as simple as “buy low, sell high.” At best, it might be “buy low, sell high, pay tax high, do Backdoor Roth IRA gymnastics…”
Cleared to Rejoin
If you’ve decided to buy the merge on a home purchase, you’ll have a lot of decisions to make beyond carpet or tile. Your down payment planning will impact your cash available for living and investing, as well as your tax bill for the year you purchase and maybe beyond if you can deduct the mortgage interest. If you’re overwhelmed by the planning, or just need a second opinion, a disinterested fiduciary such as your installation’s personal financial counselor is a great place to get some help. Your realtor and mortgage lender have much different incentives in this transaction. A financial advisor compensated by the assets s/he manages for you probably won’t want you to reduce those assets when buying (or paying off) a house, so keep that in mind too. If you’re on short final for a home purchase, this article is a bit of a flock of turkey vultures. But financial planning is much like planting a tree—the best time was 20 years ago; the second-best time is today!
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“Winged Wealth Management and Financial Planning LLC (“WWMFP”) is a registered investment advisor offering advisory services in the States of Florida and Texas and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by WWMFP in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of WWMFP, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.