Buying a home is a major step in a person's life. It is often considered to be a significant achievement, a good investment and a celebratory occasion. However, the experience can take a negative turn if the transaction is not handled efficiently, and one of the most important factors that could affect the process is the amount that should be allocated towards your down payment.

Choosing Your Home by Down Payment
If you are able to make a large down payment towards your home purchase, you should consider whether it is wise to do so vs. buying a cheaper house. A large down payment on your dream home could mean larger mortgage payments, while choosing to use that same amount towards a home that is less than what you might consider your dream home could mean smaller mortgage payments and more money available to use to cover other expenses.

For example
Jimmy has long dreamed of living in a gated community in ABC town. He found a home that was selling for $500,000, which required a down payment of at least 20%. Jimmy has excellent credit and is able to secure a mortgage loan at a rate of 4%. Without taking his property tax into consideration, his monthly mortgage payments would be about $1,900 over a 30-year period.
Jimmy also has the option of purchasing a home of the same size in a nearby community for $200,000. This house is significantly cheaper because, while it is the same size as his dream home, it is not in a gated community and it does not include amenities that are available in the gated community such as a pool, tennis court and a golf course. Also, the exterior of this home is not as attractive as his dream home, nor does it have some of the "extras" that makes the home more attractive like crown molding, high beam ceilings, etc. However, if Jimmy pays down $100,000 on this home, his monthly mortgage payments will be only about $477 assuming the rate remains at 4%. Jimmy's second choice would leave him with more than $1,400 in monthly disposable income.

Don't Forget Other Expenses
One of the biggest mistakes that homebuyers make is to overlook their other expenses when calculating how much disposable income they will need each month. You can avoid making such a mistake by ensuring that your budget is up to date and includes all of your monthly expenses, such as utilities, other loan repayments, any car payments and insurance, and property taxes that will be owed on your new home.

If you currently live in a rented property, some of the expenses for home repairs and incidentals such as repairing a pipe to mending a fence might have been handled by the owner of the property. As a homeowner, you would be responsible for covering these items. This means you should consider setting up a rainy day fund for these items. If the availability of financial resources could be an issue, buying a cheaper home might be a better choice.

Other Positives of a Cheaper Home
Buying a cheaper home has other benefits in addition to the possibility of a lower down payment. For example, Jimmy could get a 15-year mortgage instead, and his payment would still be only $739, which is still a lot less than if he buys the more expensive home. Alternatively, Jimmy could pay down the required 20% ($40,000), which would make his payments about $1,180 and leave him with $60,000 to add to his savings or use for other purposes. Consider, too, that lower monthly payments and more disposable income means being able to add more money to long term savings, such as your retirement nest egg and college funds. Finally, it could mean the difference between being able to stay in your home vs. going into foreclosure if your financial status takes a negative turn.

Alternate Solutions
If you heart is set on a certain type of home, you may still be able to get such a home at a lower price if you shop around. Houses are much cheaper than they were five (or more) years ago because of the status of the housing market, and your options include foreclosed homes as well as builders who are trying desperately to get rid of inventory that has been stagnant for long periods.

The Bottom line
When deciding how to use your down payment on a home, be sure to consider all the pros and cons so as to help ensure that your dream does not turn into a nightmare. Getting your dream home is great, but being able to cover your expenses and build up your nest egg can be even better.

Related Articles
  1. Credit & Loans

    Understanding Home-Equity Loan Rates

    Shopping is the most important part of getting a home-equity loan. You're going to have to live with the terms for a long time.
  2. Insurance

    5 Ways to Lower Life Insurance Premiums

    Learn several effective methods for lowering life insurance premiums. These include quitting smoking and considering term life insurance.
  3. Budgeting

    The 7 Best Ways to Get Out of Debt

    Obtain information on how to put together and execute a plan to get out of debt, including the various steps and methods people use to become debt-free.
  4. Credit & Loans

    5 Signs a Reverse Mortgage Is a Bad Idea

    Here are the key situations when you should probably pass on this type of home loan.
  5. Credit & Loans

    5 Signs a Reverse Mortgage Is a Good Idea

    If these five criteria describe your situation, a reverse mortgage might be a good idea for you.
  6. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  7. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  8. Home & Auto

    Renting vs. Owning: Which is Better for You?

    Despite the conventional wisdom, renting might make more financial sense than you think.
  9. Credit & Loans

    Guidelines for FHA Reverse Mortgages

    FHA guidelines protect borrowers from major mistakes, prevent lenders from taking advantage of borrowers and encourage lenders to offer reverse mortgages.
  10. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
RELATED TERMS
  1. Cost Accounting

    A type of accounting process that aims to capture a company's ...
  2. Equity

    The value of an asset less the value of all liabilities on that ...
  3. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  4. Comprehensive Glass Policy

    An insurance policy that covers glass that has been broken or ...
  5. Chattel Mortgage Non-Filing Insurance

    An insurance policy covering losses that result from a policyholder ...
  6. Zombie Foreclosure

    A situation (or a home in this situation) that occurs when a ...
RELATED FAQS
  1. Can I take my 401(k) to buy a house?

    Once you reach 59.5, you can use the funds in your 401(k) retirement savings account to buy a house or any other expense ... Read Full Answer >>
  2. Can I take my 401(k) to buy a house for my children?

    Under the standard regulations for 401(k) retirement savings plans, you may elect to withdraw funds from your 401(k) for ... Read Full Answer >>
  3. How is market value determined in the real estate market?

    Anyone who has ever tried to purchase or sell a home has probably heard a lot about the property's fair market value, or ... Read Full Answer >>
  4. How does a bank determine what my discretionary income is when making a loan decision?

    Discretionary income is the money left over from your gross income each month after taking out taxes and paying for necessities. ... Read Full Answer >>
  5. What are the main factors that impact share prices in the insurance sector?

    The main factors that impact share prices in the insurance sector are interest rates, earnings and actuarial risk. In the ... Read Full Answer >>
  6. Why do insurance policies have deductibles?

    Insurance policies have deductibles for behavioral and financial reasons. Moral Hazards Deductibles mitigate the behavioral ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!