House Buyers – Is 20% Down Payment Always Better?

by Mike Holman
Money Smarts
www.moneysmartsblog.com


In Canada, if you buy a house and have less than a 20% down payment, you have to pay a CMHC (Canada Mortgage and Housing Corporation) fee to insure the mortgage.  It should be the goal of all home buyers to have a larger down payment, but it’s not always possible.

One scenario is where someone has enough money to make a 20% down payment and is wondering if they should use all the money for the down payment or put down a smaller down payment and use the extra cash for other things.  Another scenario is where a buyer is close to reaching 20% down payment and only has to borrow a small amount of money to reach 20%.  Should they do it?

I can think of three examples where a person bought a house with a smaller down payment, even though they had enough money or means (via borrowing) to reach the 20% necessary in order to avoid the CMHC fee.  One blogger shall remain nameless, the other person was me (12 years ago) and the third person is a blogger at Moneyville, which is owned by the Toronto Star.  I’m going to use Madhavi (the Moneyville blogger) as my example, only because she is the most recent.

Madhavi and her family owned a condo, which they sold and bought a family house.  They netted $115,000 from the condo sale and bought a house for $560,000.  20% of $560,000 is $112,000, which means she could have put down a 20% down payment and avoided the CMHC fee.

Instead she decided to use roughly half of the money to pay down debts ( a worthy use ) and only put down a 10% down payment.

The problem with only paying a 10% down payment is that you have to pay the CMHC fee.  Does that mean she paid a big fee just to consolidate some unsecured debts?

She mentioned in the article that the CMHC fee was $12,000 including tax.  Had she put down $115,000 down, the CMHC fee would have been zero since mortgages with a 20% down payment or higher do not require insurance.

By using a smaller down payment, Madhavi was able to reduce the interest rate on $59,000 of debt.  If we’re going to analyze the wisdom of paying a $12,000 fee, we have to include the interest cost benefits as well.

The average interest rate of the unsecured debt that was paid down was not mentioned, but she did say that $45,000 of it had interest rates from 6% to 10%.  For argument sake, let’s assume that the average interest rate of all the $59,000 debt she paid off was 4% higher than her mortgage rate.

In other words, she paid $12,000 to decrease the interest rate of $59,000 of debt by 4%.

As to whether this was a good move or not – we have to consider how long she would have taken to pay off the $59,000 of unsecured debt, had she not used part of her down payment money to pay it off.

4% interest on $59,000 for one year is $2,360.   If she doesn’t pay the principal down at all – it will take five years for the interest saved to equal the CMCH fee.  After that, she will have saved money by using a smaller down payment.

If she would have paid down the $59,000 quick enough to keep the total excess interest (4%) cost below $12,000, then she would have been better using 20% down and avoiding the CMHC fee.

Of course, it’s impossible to know what the future holds, but I would suggest that in Madhavi’s case, it’s likely that paying a smaller down payment and paying the CMCH will have a neutral or positive outcome.

The reason I say that is because if you buy a house when you have a lot of unsecured debt (at least $59,000 in Madhavi’s case) and it appears that the house cost itself is a stretch – I don’t think it’s likely that they would be in a position to pay off extra debt very quickly.

Had they put 20% down and saved the CMHC fee, they would have had higher monthly payments, probably would have taken quite a while to pay down the unsecured debt and would have paid more in extra interest than the CMCH fee cost.

What if I don’t have any or much unsecured debt and have to borrow to reach 20%?

Madhavi bought a house with a huge amount of unsecured debt.  I suspect it is more common for people to buy houses who have little or no debt (other than an existing mortgage).  For this scenario, the numbers change quite a bit and it is a lot more likely that if you can borrow enough money at a reasonable rate to make the 20% down payment, you will come out ahead.

What if I have the 20% down payment, no debt, but need some money for other things?

If you have the cash for 20% down payment already and little or no debts – it’s a no brainer.  You must use the cash for the down payment and then just borrow any money you need for closing costs, furniture etc.