Are you dreaming for a home to call your own?
If so, you’re likely saving up - dollar by hard-earned dollar – waiting for that day when you’ll have that magic number for your down-payment: 20%. At least that’s what you’ve been told, right? Well, take heart! A 20% down-payment isn’t always required, which is good news for you because for the average American saving 20% of the purchase price of a house can take years!
Yes, you read right. The 20% down-payment myth is an unfortunate leftover from the era following the 2007 housing crisis, when out of necessity, access to credit tightened significantly after many borrowers defaulted on their loans. Thankfully, times have changed, the housing market has recovered and many lenders no longer require that large a down-payment.
While it’s true that a higher down payment means you’ll have a smaller monthly mortgage payment, there are plenty of reasons why the 20% down isn’t always the best road to owning a home.
Let’s explore loan options that don’t require 20% down and take a deeper look at the pros and cons of making a smaller down payment.
Government Backed Loans
1. FHA mortgage: This loan is backed by the federal government aimed at helping first-time home buyers and requires as little as 3.5% down. If that number is still too high, the down payment can be sourced from a financial gift or via a down-payment assistance program.
2. VA mortgage: VA mortgages are the most forgiving, but they are strictly for current and former military members. They require zero down, don’t require PMI, and they allow for all closing costs to come from a seller concession or gift funds.
A conventional loan is the most common type of mortgage, and some only require a down-payment of as little as 10, 5 or 3 percent. These requirements vary based on income, other assets, credit score, co-borrowers, and even the lender (a mortgage broker versus bank or credit union). Additionally, in the absence of 20% equity (either in the appraised value or your down-payment) most lenders will require private mortgage insurance (PMI), which can add an average of $75 - $125 a month to your monthly payment.
So why make a smaller payment?
If a conventional loan with a smaller down-payment means that a portion of your monthly payment isn’t even going toward increasing your equity in your home, you may ask why you should even consider this option. Well, consider this. a RealtyTrac study found that, on average, it would take a homebuyer nearly 13 years to save for a 20% down payment. If you paid $750 a month in rent for 13 years you would have shelled out over $115, 000 and have nothing to show for it.
Other benefits to putting down less than 20% include the following:
Pay off other debt: Many lenders recommend using available cash to pay down credit card debt before purchasing a home. Credit card debt usually has a higher interest rate than mortgage debt – and it won’t net you a tax deduction.
Capitalize on low rates: The economy is fluid, thus so are loan rates. If rates are really low, like they are now, it makes sense to get yourself into a home as soon as possible because the difference in even one percent over the life of a 30 year loan can mean tens of thousands of dollars.
Build an emergency fund: As a homeowner, having a rainy-day fund is crucial. From here on out, you’ll be the one paying to fix any plumbing issues or that leaky roof, and home repairs can be very costly.
Decorate or remodel: Few homes are in perfect condition, and either way you’ll likely want to make some changes to your new home before or soon-after you move in. Having some cash on hand will allow you to do that without going into debt.
Cons of smaller down payments
In all fairness, there are some drawbacks of making a smaller down payment though, and we would be remiss if we didn’t tell you about them.
Private Mortgage Insurance: PMI is an extra monthly expense piled on top of your mortgage and property tax and it doesn’t go towards the balance of your loan. As mentioned above, though, PMI is temporary. Once you have 20% equity in your home – either through payments or increased home value – it’s no longer required and the extra money can go straight to paying off the balance of your loan.
Potentially higher mortgage rates: If you’re not putting down 20%, you usually won’t qualify for the lowest rate. Often the lowest rate requires a credit score of 720 or above, a low debt to income ratio, and are available on loans with shorter terms like 10 or 15 years, or those where there is a significant equity investment right out of the gate.
Less disposable income: with a higher monthly payment comes less money for other things. This means often discretionary spending for things like eating out and monthly subscription services often has to be sacrificed, and it can make it harder to direct money to the rainy date fund.
Of course this doesn’t mean you should buy a home no matter how much – or how little – you’ve got in your savings account. Before making this decision, be sure you can really afford to own a home.
Would you like to know more about the home buying process? Visit our mortgage center or give us a call at (409) 898-3770. Our team of experts are be happy to answer all of your questions. Or, visit our FiEd Resource Center where you will find a variety of articles, videos, eBooks and infographics to help you navigate the best path to financial success.