The 20% Down Fallacy

The 20% Down Fallacy

When looking for an investment property, it is commonly understood that a 20% down payment is needed.  However depending on the property and the market, the standard 20% down might not make the property cash flow.  This doesn’t mean that the property is a bad real estate investment, it just may require a different strategy.

Why 20% down

An industry standard is based around putting 20% down on a house.  This percentage is determined by Fannie Mae and Freddie Mac (two government sponsored lenders) that back most home loans in America.  When a buyer puts down less than 20% they don’t meet the industry threshold for equity, and an additional PMI (Private Mortgage Insurance) which is an added monthly cost.

PMI protects the lender in the event that you default on your primary mortgage and the home goes into foreclosure.

Additionally this 20% down requirement is for non owner occupied properties.  It is possible to put down less than 20% if your intent is to live in a house for a while and then rent it out, but if this home purchase will be as a pure rental, than lenders generally require the 20%.

I would like to add that if you own an house, one that you purchased as a primary home, and have lived there for a few years. then decide to get into the rental game, there isn’t anything you need to do.  You can buy another house, as a primary residence, and rent out your old home.  At this time I can’t think of any restrictions, but it’s always good to check with a local agent in your market.

When 20% down doesn’t cash flow

Aside from all the above rules regarding owner occupancy, PMI, and Equity, the 20% down payment might not be enough for your house to be profitable every month.  I’m not talking long term equity here, where the house value goes up over time, but instead the month over month profitability.

Let’s take a common example I encounter almost every day.

A new buyer / investor calls me and we begin to talking about their goals, and requirements.  One of the main ones I hear is that they want the house to go to highly rated schools.  No problem I say, I can easily show you homes that go to tightly rated schools.  We go look at the house and it fits all their other criteria – so we begin to crunch numbers.

On average the rental rates here in Austin are about $1.00 per square foot.  Some areas are a bit more, some are a bit less, but the $1 is a good rule of thumb to start estimations with.

Now, let’s say this house is 2,500 square feet.  So the rental rate is $2,500.  A little bit more or less won’t affect our estimation in this case.

In my experience (and validated by data) homes that go to highly rated schools typically cost more than other homes.  Parents pay a premium for the opportunity.  Homes cost more. And as a result the mortgage costs more.   Once common area in Austin with highly rated schools is Avery Ranch – homes in this area commonly cost $482,000 (on average).

When you calculate the mortgage payment on a $482K house (20% down ($86,000), including taxes, insurance, interest) the monthly payment is just over $3,000 ($3,057 by my calculations).

So take the monthly income of $2,500, and deduct the expenses of $3,000 and you have a negative cash flow of $500.  Every month you are short $500 in paying the mortgage.

Instead, you will need to bring 39% down to make the numbers work

It’s OK to put down more than 20%

Now, I understand not every first time investor has $188,000 to bring as a down payment.  And that’s totally OK.  We just need to focus on homes that meet your down payment criteria.

For me, investing is all about the numbers.  I’d rather have a house that is cash flow positive, but maybe not in an A+ school district.  It may be on the other side of town.  It might be a 3 bedroom and not a 4.  Perhaps it doesn’t have the nicest finishes and upgrades.

That’s all OK.

You just have to figure out your priorities and where you are willing to compromise.  If you want a rental house in a good school zone, it might be that you have to save more as a downpayment, or be OK with negative cash flow.

Whatever you decide, let me know in the comments below. Our readers would love to know your strategies.