Do I really need to save a 20 per cent deposit?
When it comes to buying a house, you may find yourself in a position where you need to weigh up whether you should spend money on Lenders Mortgage Insurance (LMI) or whether you’re better off waiting until you have a 20 per cent deposit to put down. You also need to consider the opportunity cost of choosing one option over the other so you can make the best choice possible for your needs.
What is opportunity cost and how does it work?
According to Shopify, opportunity cost is an economic term that refers to the value of what you must give up in order to choose something else. In a nutshell, it’s the value of the road not taken. For example, there are hidden opportunity costs when choosing whether to go with LMI vs having a 20 per cent deposit. We will unpack in this blog the opportunity cost for each, and what you may miss out on by choosing one over the other.
Choosing Lender’s Mortgage Insurance
Firstly, let’s chat about what LMI is, before heading into the pros and cons associated with it. LMI is a one-off, non-refundable, non-transferrable premium that is added to your home loan. This insurance fee only happens when the purchaser does not have enough money to cover a 20 per cent deposit. The exact cost of the LMI is calculated based on the size of your deposit and how much you are looking to borrow.
Interestingly, a large 70 per cent of borrowers believe that LMI protects them in the event of a default – this is not the case. Lenders mortgage insurance (as explained above) is there to protect the lender in case you can’t make your mortgage repayments.
For more information, read our blog on Lender’s Mortgage Insurance.
Now that we know what LMI is, let’s look at it in terms of opportunity costs and pros and cons. The first obvious benefit is being able to potentially take out a mortgage with a smaller deposit than the usual 20 per cent required. This means, especially for first home buyers, that you will be able to get into the market a lot sooner.
A downside of LMI is that it is there to protect the lender – not you. If you do default on repayments, an insurance claim is made and you are likely to be obliged to pay the premium. The insurance provider may also attempt to recover excess money in the event of a shortfall. Another con of LMI is the cost associated. This cost is usually a percentage of how much of a deposit you have, versus how much you would be borrowing, so differs for everyone.
When it comes down to looking at opportunity cost, the opportunity presented to buyers who use LMI is that they can get into the property market sooner, which also means they can start earning equity on their house and potentially benefit from what’s happening in the market. This equity could then be used for purposes such as further investing in another property, investing in the share market, renovating your current home, or making a large purchase such as a car or boat.
Choosing a 20 per cent deposit
While the common belief that you need 20 per cent for a home deposit is slowly beginning to fade, there are still a lot of people who would prefer to put down a larger deposit rather than paying LMI. Saving up enough to put down a larger deposit rather than paying LMI on a smaller deposit comes with its own set of pros and cons. Starting with the pros, having a larger deposit means you won’t have to pay extra for LMI. It also means you’ll pay less interest to the lender since a larger deposit results in a smaller loan.
Another benefit of saving a larger deposit is the potential to be able to increase your borrowing power. The more money you have saved, the less of a risk you appear to a potential lender, meaning that you may be able to borrow more. It can also give you the opportunity to unlock special lender discounts and deals for those who have a larger deposit saved.
When it comes to the downfalls of choosing a 20 per cent deposit over LMI, the main one to consider is that you could be waiting a lot longer to break into the property market. Having a property will allow you to accrue equity as the market fluctuates, so the longer you wait to get into the market, the longer you will be waiting to start getting equity on your home. The other thing to keep in mind is that as the market changes, house prices might go up. If you are aiming, for example, to save $100,000 to purchase a $500,000 property, the type of property you can purchase now for that amount versus the type of property you can purchase when the time comes may be completely different if house prices increase. For example, if you had a 20 per cent deposit saved in December 2020, you would need to have saved an additional $691 per week to maintain your 20 per cent deposit based on the median house price in Melbourne going up by 4.8 per cent to $974,397.
Using equity to purchase another property
When looking at the opportunity cost, the potential to miss out on getting your foot in the real estate market door and generating equity on a property is what you risk by waiting to save a larger deposit. Inovayt Mortgage Broker Newcastle, Ben Robinson says, “If a client comes to me looking to buy a property and doesn’t have a 20 per cent (plus costs) deposit and doesn’t have access to obtain this quickly, I would encourage them to pay LMI.” He also advises that if you do want to wait a few years to save a 20 per cent deposit (based on house prices now), in a few years’ time when you are ready to buy, the housing market might have increased, meaning you will have to keep saving to meet this deposit amount. You are essentially just chasing your tail.
How do I know what’s right for me?
With every financial decision, there is an opportunity cost that comes with making a choice – especially when it comes down to deciding between paying LMI or waiting until you have a larger deposit before purchasing a house. We understand that everyone’s financial situation is different, so it’s a good idea to chat with one of our mortgage broker team members for advice before making a decision.