Traditional wisdom is that you should always put down 20% on a home purchase. After all, much of the housing crash of 2009 was caused by too-low down payments on overvalued homes. However, many younger buyers are looking around and realizing they’ll never save enough for a 20% down payment on the houses available in their market. Is it possible or safe to purchase a house with a lower down payment?
The answer is yes, but the exact amount you will need to put down will vary based on your circumstances. You’ll need to make sure you find mortgage terms that won’t penalize you for putting less down.
Lower Down Payments
Despite traditional wisdom, the average homebuyer only pays a 6% down payment. A few mortgage options allow you to put nothing down, but conventional mortgages start at 3%. A lot will depend on your financial situation. If you have a high credit score and a low debt-to-income ratio, you’ll have a better chance of being approved for a mortgage with a lower down payment. Even so, your interest rate will be higher the less you put down.
VA (Veterans’ Affairs) and USDA (United States Department of Agriculture) loans can go as low as 0% down. For VA loans, you need to be a veteran, and for a USDA loan, you must buy in a rural area and meet income limits.
FHA (Federal Housing Administration) loans allow you to put down 3.5%, even if your credit score isn’t that high. However, the home you buy will need to meet certain standards. Also, you will have to pay mortgage insurance for the life of the loan.
Mortgage Insurance
How can banks afford to lend money with so little down? Normally, if a homebuyer defaults on a mortgage, the bank forecloses on the house, which compensates them for the loss. But if you’ve put very little down on the house, the value of the house itself might not be enough to compensate them for the money they lent you to buy it.
The answer is mortgage insurance. This is a monthly payment you will make to insure your mortgage against the risk you will default on it. Since the risk to the bank is reduced, they’re more willing to offer a mortgage, even with a lower down payment. Plus, the economic system is protected against large-scale defaults, as happened in the 2009 foreclosure crisis.
The result is that, if you pay a lower down payment, you will have a higher monthly mortgage payment. There’s no getting around that. Mortgage insurance may add $100 or more to your monthly payment. Conventional loans will have the highest mortgage insurance payments, whereas USDA loans have lower mortgage insurance and VA loans don’t have it at all.
The silver lining is that with most loans, you won’t have to pay mortgage insurance forever. Once you have paid enough on your mortgage that you reach 20% equity, you can request to have the mortgage insurance removed. Once you reach 22% equity, it will usually be removed automatically. But, since having it removed sooner means thousands of dollars you don’t have to pay, you should request to have it removed as soon as possible.
How to Reduce Your Down Payment
The easiest way to reduce your down payment is to choose a less expensive home. As a first-time homebuyer, you don’t have equity in your current home to use on your down payment. That means you will likely need to buy a starter home, something at the bottom of the range for homes in your area. After building equity for five or more years, you may be able to upgrade to a nicer home.
Depending on your state, there may be down payment assistance programs available to you. These come in the form of grants, which don’t have to be paid back, and various types of loans. Some of these loans are forgivable so long as you remain in the house for at least five years. Others come with zero interest or deferred payments. Often, you will need to take an educational class and meet income limits.
One important point to remember, when saving for your down payment, is that you will also need money for closing costs. This can run from 2-5% of your loan amount. So your savings goal should be 5-8% of the cost you expect to pay for a home. And this should be separate from your emergency fund—emergencies can happen the month you buy a home, just like they can at any time. If you don’t expect to be able to save this amount due to low income, look into down payment assistance. But if your income is high and you still aren’t meeting these savings goals, it may be time instead to consider tweaking your budget to save more.
Get Help Meeting Your Goals
If homebuying is a major dream for you, a financial advisor can help you create and meet a savings goal. They can also warn you away from mortgage options that aren’t wise for you. A mortgage can have a financial impact on your life for 30 years. It’s definitely worth it to obtain the best advice available before you sign the papers.To find the right advisor for you, contact us. We can match you with someone knowledgeable about your specific challenges and stage of life.
