Mortgage lenders traditionally have wanted to see borrowers put down 20% of a home’s purchase price. But what are the benefits and challenges of a down payment that’s less than 20%?
Lenders traditionally have wanted to see borrowers put down 20%.
The upshot: Is 20% down dated advice?
Let’s look at these questions and more to help you qualify for a home loan and ultimately turn your dream house into a reality.
Qualifying for a Mortgage Loan
The question of how much to put down on the house is really a subset of a bigger homebuying question: whether the house you want is within your budget.
Many house hunters take their household gross annual income (before taxes) and multiply it by 2.5. That would be the most, they decide, they can afford a house.
So, if your household income is $150,000, the maximum purchase price, using this formula, would be $375,000. Note that this isn’t a formula used by a lender; it’s a general rule of thumb that people use.
A lender often wants your total housing expense—monthly principal, interest, property taxes, and insurance, plus any homeowners association fee or private mortgage insurance—to be, at most, 28% of your gross monthly income.
So, using the figure of $150,000, that would equal a maximum housing expense of $3,500 per month ($150,000/12 x 28%).
Your estimated housing payment will depend on how much of a down payment is applied. For example, let’s say the house you want costs $329,000, which happens to be the recent median existing-home sales price nationwide.
If you were to finance the home, you’d need $65,800, plus closing costs, to swing a 20% down deal. So the first question is whether you have or can get those funds easily enough.
If the answer is “yes,” then you can check your income against the formulas provided to see if it all works out according to plan.
If you don’t have that kind of cash for the down payment—if you could afford a smaller down payment plus closing costs and still meet the income requirements—your next step would be to see which lenders offer home loans with that kind of program.
Mortgage loans generally fall into two categories: loans insured or guaranteed by the government and loans not insured or guaranteed by the government, which are called conventional loans.
Government-backed mortgages are often easier to qualify for than conventional mortgages.
One home loan option is a Federal Housing Administration (FHA) loan. FHA loans are a government program initially created to help people buy homes during the Great Depression. It’s still available, and people who can’t afford larger down payments might choose this option.
The FHA doesn’t directly make mortgage loans. Instead, certain lenders offer FHA loans that are backed by a government guarantee. Because of this guarantee, lenders will typically offer more flexible guidelines for mortgage approvals, including the down payment size.
FHA loans require an annual mortgage insurance premium (MIP) and an upfront MIP of 1.75% of the base loan amount. You’ll typically pay the MIP for as long as you have the loan unless you make a down payment of at least 10%. If that’s the case, your MIP will be canceled after 11 years.
How much is the MIP? A rate of 0.85% applies to borrowers who put down less than 5% on a 30-year FHA loan for $625,500 or less. You can estimate the upfront and ongoing MIP at fha.com/calculator_payments.
If you’re a military veteran, active service member, or, in some cases, a surviving military spouse, you may qualify for a U.S Department of Veterans Affairs (VA) mortgage loan without a down payment.
The US government created this program in 1944 to help people returning from military service purchase homes.
Monthly mortgage insurance is not required, but a one-time funding fee is for some borrowers. For example, for a first VA-backed purchase or construction loan, the fee is 2.3% of the total loan amount if you put less than 5% down. It’s 1.65% of the loan amount if you put 5% to 10% down.
Some private lenders provide conventional loans for homebuyers with less than 20% down. Almost always, in these cases, you’ll need to purchase private mortgage insurance (PMI) that insures the lender.
PMI adds a fee to the monthly mortgage payment.
PMI can be an annual 0.5% to 2.25% of the total loan amount, with the premium amount depending on the type of mortgage you get, your down payment, your credit score, and loan term. It also depends on the amount of PMI that your loan program or lender requires.
Borrowers usually choose to pay PMI monthly, and it is included in the monthly mortgage payment. Expect to pay about $30 to $70 per month for every $100,000 borrowed, Freddie Mac says.
You can ask to get rid of PMI after you accumulate 20% equity and have a good payment record, there are no liens on the property, and the value has not declined. (PMI usually must end once you have 22% equity in your home, based on the original purchase price, if you’re current on payments.)
You may also be able to get rid of PMI if your home’s value rises enough to give you 25% equity and you’ve paid PMI for at least two years.
This applies to borrower-paid mortgage insurance. You can’t cancel lender-paid mortgage insurance when your equity reaches 78% because it is built into the loan.
How Big Should Your Down Payment Be?
The average down payment falls below 20%, so if you can’t cough up 20%, you’re in good company.
In general, it makes sense to put down as much as you can comfortably afford. The more you put down, the less you’ll be borrowing, which translates into more equity in the house and lower monthly payments. Plus, with a lower mortgage amount, you’ll pay back less interest over the life of the loan.
On the other hand, it doesn’t always make sense to empty the bank to put down the largest down payment possible. That’s because you’ll likely have moving expenses, plus you’ll need to pay closing costs, which can vary by a purchase price, the state in which property is located, the interest rate is chosen, lender processing fees, and more.
Furthermore, the home you’re moving into may need cosmetic repairs, or you may want to redecorate, add new landscaping, and so forth. Plus, you’ll probably want to keep an emergency fund to pay for unexpected costs.
If this doesn’t all seem doable, you may want to look for a more affordable house for now and save up for your dream house. Or, if you can wait a while before buying, then you can create a savings plan to build up a down payment.
Saving for a House
For 58% of recent buyers, their down payment came from savings (a fortunate 10% of buyers used a gift from a friend or relative toward the down payment), according to a 2021 National Association of Realtors® report.
Saving can be difficult, to be sure. In the Realtors®’ report, nearly half of respondents said that saving for a down payment was difficultly attributed to student loans and 36% credit card debt.
But if you are ready to be a homeowner, now is the time to get serious about saving.
Here are steps to consider taking:
1. Track your spending, including fixed expenses (rent, utilities, car payments, and so forth) and variable ones (like dining out, clothes shopping, and hobbies). Add expenses that you pay annually or semiannually, breaking those down into monthly amounts.
3. Brainstorm ways to boost your income. Asking for a raise may be an option.
4. Figure out what you can save each month, both for emergency expenses and your house fund.
5. Set a timetable for your plan.
If you can manage a down payment, but it’s south of 20%, know that you’re in good company. Finding a mortgage with less than 20% down is often doable, though fees usually come along for the ride.
This post originally appeared on Sofi.com
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