3.5% down or 25%?

Question

I’m debating how much to put down for my first investment property. I’ve heard the adage that you should always put as little down as possible, but this is only because investors always figure they will find a smarter way to invest that money even if they pay more dollars in interest overall.   personally, I don’t plan to buy another property  or really invest that money for the next 3 years minimum anyways, so I believe I may as well put the money down to get a low mortgage and start cash flowing sooner. Those 3 years is more than enough time to earn enough to put 3.5% down when I’m really ready to start investing continuously. That’s what I’m thinking at least. Am I missing any benefits of smaller down payments?

Ray Williams · Answer

Partially depends on if you are occupying or not. You can put less down when you occupy. If it is a rental, you can't. The property will appreciate the same % regardless of leverage, rate, etc. Have you evaluated opportunity cost? Meaning, where is the money now, and what would the lost returns be if you sunk the capital into an RE acquisition, assuming primary residence? A good problem to solve for.

Evan Polaski · Answer

@Matthew Mclean, as you are seeing there is a lot of factors that go into this.  Some are very tangible and some less so.

First, can you even do 3.5% down?  As noted, this is typically an FHA loan, so limited to owner occupant 4 units or less.  Many commercial lenders (5+ units) will require 20, if not 25% down.

Second, what other reserves do you have?  If 25% down is all of your available capital, than you shouldn't consider it.  No matter how good the inspection is, a water heater, furnace, roof can all fail even if they visually look fine.  Or more likely, a tenant can do $20k in damages upon move out 2 months after you take ownership, and skip town leaving you to foot the bill.

Effective cost of capital: at 3.5% down you are likely paying higher interest and PMI each month.  As well as higher closing fees, typically, for lower down payment mortgages.  You need to determine these extra costs and then assess if the "return on investment" is worth it to put more down.

Opportunity cost: your intent is not to invest again for 3 yrs, but why?  If you tie up more capital, there is always a chance you won't have it available when that perfect deal comes.  Alternatively, if you wait for the perfect deal, you could likely be sitting on idle capital, while paying more on your deployed capital.

Mental component: higher debt typically means more risk.  If you only put 3.5% down, beyond the likely higher cost per dollar noted above, every day your property sits vacant costs you more money.  This can create a very significant amount of stress.

At the end of the day, given mortgage rates are currently 7% for 30 yr fixed, owner occupant, and likely higher for commercial, if you can put 25% down and still have more reserves available if needed, I would personally put more down.  You are automatically making 7% on that money, and given most rentals are not yielding anything near that amount from cash flow, AND the S&P historically averages 8%/yr over the long term, for me I would put more in.  As I get comfortable with owning a rental, and rates possibly come down, you can always refi into a lower rate mortgage and tap into the likely equity growth you will see just from market conditions, when rates do come down.

John Princinsky · Answer

@Matthew Mclean

The less you put into the property, the higher your rate of return as it appreciates.

Example: 100k property appreciates to 104k

If you bought it cash you would have made a 4% return.

If you put 10k down you would have made a 40% return.

Even if your extra cash gets put into an index fund, when you factor in your “effective percentage rate” (your interest rate with tax deductions factored in- assuming that you itemize instead of take the standard deduction), you are most likely going to get a better return for your money that you invested.

If it were me- I’d do a 40 year interest only mortgage with 0% down if I could lol.

But of course- everyone has their own idea of ‘risk’ and discipline in managing their investment(s).

If you DO decide to put a larger amount than needed down- some may consider also getting a HELOC for the equity (even if you don’t borrow from it) as an ‘insurance’ policy to easily be able to access your equity without having to sell the property or worry about being able to qualify for a refi down the road.

This is all conceptual, though, of course. It will entirely depend on your exact situation.

Michael Thach · Answer

You pretty much answered your question. If you don't invest into another property in 3 years and you would not do any other investment with the money, then it's ok to put 25% down. Is a very passive investment style. The big question is why not putting 3.5% down and buy another property with 20-25% down within couple months ? Interest rate will go down this year. For 1% interest rate decrease we will see about 8-10% appreciation. Why missing out on 16-20% appreciation ?