If there’s one thing that pretty much everyone agrees on, it’s this: when buying a house, using a 20% deposit (or more) is the way to go.
After all, it comes with several benefits…
Substantial interest savings. Lower repayments. No need to pay LMI (lender’s mortgage insurance). And it gives you a good head start in becoming a debt-free homeowner.
But is it always the best move? I mean, you might also be trying to rapidly build a portfolio of investments for financial independence.
What if you used a smaller deposit so that you could invest more instead? And what about using a smaller deposit so that you can buy your home sooner?
Let’s explore these ideas.
A quick note on Lender’s Mortgage Insurance (LMI)
What is it?
LMI is an insurance policy which is typically taken out when a borrower wishes to have a loan which has a loan-to-value ratio (LVR) higher than 80%.
This policy is paid for by the borrower, and is commonly in the range of 1-3% of the loan amount. Yes, that means many thousands of dollars!
And it’s to protect the bank, not the borrower. Why the bank?
Because high LVR loans are considered riskier. If the borrower defaults, the bank would sell the property to recoup their money. But if the property value has fallen, given the high LVR, the bank may not be able to get their money back. Hence the insurance.
While it sounds pretty crappy for a borrower, it’s not all bad. You’d only agree to it if you were happy with the trade-off. By borrowing more than 80% and paying LMI you can:
- Get into your own home sooner
- Use smaller deposits to buy multiple properties (what we did)
- Keep more cash for renovations or a buffer
- Invest more into other assets like shares
Let’s work through a few examples and see whether the benefits are worth the cost.
(Notes: Like most examples, I need to use some round numbers and basic estimates for practicality. I’ll assume stamp duty and other costs amount to 5%. First homebuyer benefits vary by state and LMI amounts and rules vary by loan size, lender, etc so it’s too messy to include these. Focus on the big picture, rather than getting stuck in the details.)
Using the recommended 20% deposit to buy your home.
You’ve been saving for a few years and you want to buy a property for $600,000.
You have a 20% deposit saved up – $120,000 – as well as 5% for stamp duty and other costs. Here’s how the numbers look.
- Loan term: 30 years at 2.5%
- Property price: $600,000
- Mortgage size: $480,000
- Cash input: $150,000 (deposit plus 5% costs)
- Monthly repayment: $1,897
- Total repayments: $682,769
- Interest charged: $202,769
It’s pretty amazing to see how much interest is paid over the life of a home loan. And this is with extremely low interest rates! No wonder people want to get rid of it ASAP.
Overall, our homebuyer has forked out $832,769 over 30 years (cash input + total repayments).
But instead of this, what if they decided to buy with a much smaller deposit and invest the rest of their savings? Let’s see.
Buy with a smaller deposit and invest the surplus
We’ll assume the same as before. $600,000 purchase price, and $150,000 cash available.
But this time, instead of a 20% deposit, they put in a 5% deposit ($30,000) and pay LMI. Using this LMI calculator from one of the big providers Genworth, this example give us an LMI premium of about $24,000.
- Loan term: 30 years at 2.5%
- Property price: $600,000
- Mortgage size: $570,000
- Cash input: $84,000 (deposit + 5% costs + LMI)
- Monthly repayment: $2,253
- Total repayments: $810,789
- Interest charged: $240,789
Wow, okay. So a few things are different here.
The total repayments are way higher, and interest costs are about $40,000 more, or 20% more than when a big deposit was used.
Overall, our small deposit homebuyer has forked out $894,789 over 30 years (cash input + total repayments).
In total, they paid $62,020 more than our big deposit buyer!
On the other hand, their cash input was $84,000 instead of $150,000. This means they can start investing with the remaining $66,000.
If we assume a return of 6% per year after tax, this chunk of money would compound to become $379,070.
So, even after accounting for the increased housing costs, our small deposit buyer is still up by $317,050.
But this isn’t quite the whole story. Because our large deposit buyer has lower mortgage repayments, there’s a monthly surplus available to invest, that our small deposit buyer doesn’t have.
Using a large deposit and investing the monthly surplus
As you may recall, our large deposit buyer’s mortgage repayment is $1,897. So she actually has $356 extra cash each month compared to our small deposit buyer, since his mortgage costs $2,253.
- Large deposit buyer monthly repayment: $1,897.
- Small deposit buyer monthly repayment: $2,253.
- Extra cash available to invest each month: $356.
Over 30 years, this seemingly small monthly investment growing at 6% per annum becomes an impressive $357,608.
By the way, these sexy graphs are from the compound interest calculator at MoneyGeek. Alright, let’s take stock of all this.
Findings from this case study.
After 30 years, here’s where we stand:
- Small deposit buyer ends up with a paid-off home and investments worth $317,052.
- Large deposit buyer ends up with a paid-off home and investments worth $357,608. A full forty thousand bucks more.
- Despite having more money invested from the start, the extra costs incurred by our small deposit buyer (LMI, higher interest and repayments) was too much to overcome.
- Perhaps counter-intuitively, the lower risk, more conservative option actually came out on top in this scenario.
But that’s not to say using a large deposit is always going to be the best method. There are definitely other scenarios where the opposite could be true.
When using a small deposit can work out better.
- If you can pay a small deposit and avoid LMI, then you can get the best of both worlds! This is possible in certain cases, like if you have a guarantor, or are deemed to be high income and low risk borrower.
- Or, you could apply for the governments First Home Loan Deposit Scheme. It seems fairly simple, and if you met the criteria, there’s no need to pay LMI. Essentially the government is backstopping your loan for the bank instead of an insurance company if things go wrong.
- Sometimes you can have LMI added on top of your home loan. This means you’d get to keep the cash, invest it, and pay a slightly higher mortgage repayment. This would help improve the outcome of the investing scenario since more money is compounding for longer at a higher rate.
- If you can achieve higher investment returns than in the example, then using a small deposit might be the better option. I prefer to have conservative expectations though.
- If you’d rather have less money tied up in home ownership and diversify your savings across different assets. This is worth considering for those who don’t want a single home to be a large percentage of their wealth. In this case you might opt to take out your home equity to invest further, or use an interest-only loan.
Something to note: In the current environment, higher LVR loans typically come with higher interest rates, which would act as a drag. But you can get the rate down as the LVR comes down.
OK, so that’s using two examples with the same timeframe. How about the idea of using a small deposit so you can buy your home sooner, even if you have to pay LMI?
Buying your home sooner and paying LMI.
First, because real estate prices increase over time, buying your home sooner means that, on average, you’re likely to pay a cheaper price.
Let’s say you’re saving up for a big deposit and you hit an unfortunate patch of strong property price growth. This has the following effect:
- It increases the amount you need to save for a deposit and stamp duty.
- You end up paying a higher (perhaps much higher) price for your home, meaning higher interest costs and repayments.
So it’s quite possible that buying sooner with a small deposit could save you money. The higher price means higher repayments, more stamp duty and more interest. Though it will obviously vary a lot by situation.
Yes, LMI is arguably a horrible cost to pay. But it’s an interesting option which does give you the ability to ‘lock in’ your house price a couple of years sooner and protect against a possible runaway housing market.
Some people point to the large deposit as a reason why housing is unaffordable. But clearly a 20% deposit is not the only option available. And for those who build a solid savings habit, it’s not too much of a hurdle. House prices alone are not the destroyer of dreams they’re made out to be.
Of course, you could also pay LMI and then prices fall after you purchase, thereby making it a painful cost you didn’t really benefit from, aside from being a homeowner sooner.
Look, I’ll be honest. I expected to find that using a small deposit and investing the surplus was going to be the most profitable option. So it was quite surprising to see the end result.
Maybe this is an overly simple example. We haven’t considered debt recycling, extra repayments or anything else. But this felt like an interesting experiment to play out, since I haven’t done it before.
All in all, using a 20% deposit seems to be a pretty solid approach in most cases. But as you can see, there’s more to it than that. In my view, the best aspect of using a large deposit is the lower monthly repayments, making life a little easier and your expenses lower.
Of course, for those that aren’t great at saving, a 20% deposit could take a frustratingly long time. But if you’re switched on and optimise your finances, it should only take a few years depending on where you live.
After that, it’s simply a case of paying down that loan or investing in a portfolio of income producing investments. Or both!
What are your thoughts on the ideal deposit size? Do you think it can make sense to pay LMI and buy sooner? Let me know in the comments.
Home loan recommendation: If you need help with anything home loan related, like finding the right lender or refinancing to a better interest rate, feel free to check out my personal mortgage broker More Than Mortgages. I’ve used Deanna and her team for many years and they’ve been fantastic.
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