What is a Down Payment, and Why do Banks Require 20% Down

 

 How does a bank think I'm going to come up with money for a down payment if I'm there asking for a loan?? 

This idea always confused me when I was buying my first home, simply because I didn't know how money worked. I didn't realize how appraisals happened, asset valuations, and market fluctuations affected a banks decision to lend to you. 

Now we'll get into the weeds of why big Banks act this way to help us understand how it can be beneficial to both sides. 

What is LTV?

Banks like to make sure their money is secure when they lend it out. They go through extensive long term processes to make sure the person receiving the loan is serious about the situation and won't try to make off with their money. 

A major thing banks do to ensure this, for homes specifically, and various business ventures is only loan a certain amount of the Assets value, or Loan To Value(LTV). That way if you ever end up upside down on your house or business the bank can take that asset that they currently have a lien against, and resell it to recoup most of the value. They're not worried about making a profit at this point, just getting what's owed to them and that's easier to do if the asset is worth much more than the loan. That's what makes LTV so important. 

The Exit Strategy

What is an Exit Strategy? Why would a huge multi national bank need such a think? An exit strategy is something every investor needs to have before they ever make the decision of throwing their money in a hat. An exit strategy is your last ditch effort to get out from under a failing asset and no matter how careful you are, it WILL happen. People make bad decisions and can't always account for every variable. 

Banks are some of the biggest investors in the world, if not THE biggest. They've just lined out the process so well and have so much money there's almost no situation where they might lose and don't need your money, because everybody's first stop for "investors" is a loan from the bank. However, banks need an exit strategy as well because at the end of the day they're just people putting faith into a business. The biggest example of a banks exit strategy is LTV or Loan to Value so they can recoup their money as quickly as possible if something goes wrong.

I can remember one situation where an exit strategy has saved me from complete and total loss and definitely highlights the importance of checking your Ps and Qs. I got a tip on an off market investment property at about 35% below market value. I went under contract right at $90,000. Comps for the house brought the value to $115,000 so with an $18,000(20%) down payment that gave me $43,000 equity and the potential to put $20,000 back in my pocket. It was currently rented to a nice older couple who planned on living out their days renting this property as long as everything stayed good on both sides, so that was perfect.

I didn't have any cash for the purchase, but really wanted to take advantage of an amazing off market deal. I just recently inquired with my bank about opening a a $20,000 business line of credit and was approved. My plan was to use the line of credit to purchase the property and then cash out within 6 months to eliminate the debt and put a few dollars in my pocket while also acquiring a performing asset. Now lets go over the safeguards I put in place to guarantee success:

• I bought the property cashflow positive. Monthly expenses came out around $670, and the property was rented for $865 per month. The GOAL of the property was to refinance or sale to take advantage of built in equity and capital gains, but buying a property at a negative cashflow is just shooting yourself in the foot.
• I had conservative comps done by a third party before going under contract. Worst case scenario the property would appraise for $105,000 and I still come out with over $12,000 in my pocket which still made it very worth it. 
• The last thing I did was verify I could take on all of this extra debt if needed. I spent a week researching the line of credit I was about to use and rerunning the numbers until I was comfortable. With the new cashflow from this property my business profit became right around $600 per month. The loan amount was $603, dang. Through my research I learned the monthly payment was based off the loan amount and changed with each payment. After the first month and a $3 loss the payment dropped to $583 and I was again cashflow positive and had recouped my $3 detriment.

....We don't put these plans in place, because everything goes well....Here's what went wrong below:

• The inspection came back with $3,000 worth of foundation damage. Seller volunteered a credit at closing, win.
• The appraisal came back right at $90,000. That's fine for the purchase, but it wasn't the goal of the purchase. At this stage I found out appraisers aren't working for you, even though you're the one that forked over the $400 for them to go look at the property. Appraisers work to ensure the bank isn't upside down on the loan amount. We submitted multiple comps and requested a new appraiser. The new appraisal came back at $98,000 which made me confident it would appraise where needed during the refinance process, win.
• Property acquisition was successful and I've started the refinance process. At this point my lender decided to make me privy to their refinance criteria. Since I wasn't occupying the residence they need a certain buffer from mortgage to the rent to be comfortable. The maximum amount of value they would loan against with $865 rent was $96,000. Crash and burn. 
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At the end of the whole process it absolutely did not work out how I planned. I couldn't refinance and get the amount of money I had planned on which was a total mess, but an amazing learning experience. If I would have purchased the property strictly to refinance and not had taken into account the extra debt I would be sinking from month to month and forced to refinance for a total of around $4,500 profit just so I wouldn't sink under a losing property and an excessive amount of debt. However, this property makes money. I've pivoted in my plan to a 2 year hold where I progressively up the rent to a point that I can actually pull my money out of it. That also gives the property adequate time to appreciate and hit high performing numbers to possibly pull out a higher amount than originally planned. None of this would have been possible without a good exit strategy. I wasn't forced to make a bad move that could have wiped me out for 5 years or more. That is the power of planning.

So why am I paying for cash for this loan?

What I've covered above about LTV and how banks save themselves sets us up to answer this very important and confusing question. You're not actually paying for the money to get this house. Think of your down payment more of an investment partnership with the bank. The bank doesn't want to be responsible for the entire amount to purchase this higher risk property, but they are willing to go into an agreement with you to buy them out of the partnership at a certain rate so you can get the home of your dreams. 

They're willing to put in 80% of the purchase price with active control of the property(lien) since they own a majority and they're letting you use that property in return for you providing their buffer of 20% of the purchase price. They're shouldering a majority of the responsibility in this situation so they stand the most to gain if anything goes wrong on your side since they bring the most to the table. Think of it a as a partnership and it becomes easier to see why they have such a strenuous process for approving your loan. Now you've got everything you need for pursuing your next major investment property or primary residence and getting the most out of the situation. Happy Spending!