A home is the most expensive purchase most people will make in their lifetime.
For years the general rule has been that you should save up to 20% of the purchase price for a down payment. But, soaring home prices and historically low mortgage rates are changing the rules for many potential buyers. “Many, especially first-time home buyers, may find it difficult to afford a large down payment,” according to Jeff Arevalo, financial advisor at Greenpath Financial Wellness, a national nonprofit credit counseling agency.
For homebuyers who can’t make a full 20% down payment, a loan – separate from the mortgage itself – can be a tempting way to cover a down payment. However, experts say it’s a bad idea with big risks. “Taking out a new personal loan to use as a down payment will negatively affect your debt-to-income ratio (DTI), which will probably be a red flag for lenders,” Arevalo warns. For most homeowners, there are other options that would be best to consider.
What is a down payment and why is it important?
“A down payment is the percentage of a property’s value that a buyer pays up front before buying,” says Andrina Valdes, COO of Cornerstone Home Lending, Inc. The reason for a down payment is to prove to a lender that you have a direct interest. in the property and maintain regular payments. “This upfront payment is used to secure the loan amount for which a borrower is eligible,” she explains. That is why most of the lenders are not compatible with the loan of the full amount of the purchase price.
With the down payment, a buyer can lower their overall loan-to-value ratio, which represents the amount they owe against the value of the home. The 20% down payment was popularized typically because it reduces the loan-to-value ratio to 80%, says Valdes.
This loan-to-value ratio is considered a less risky threshold for mortgage lenders and is the level at which lenders will not need private mortgage insurance (PMI). The PMI adds an additional cost to the borrower and is designed to protect the lender in the event of your mortgage default. PMI can be removed once your home’s loan-to-value ratio goes down.
A larger down payment can translate into better financing options for your mortgage, including helping you get a lower mortgage rate, says Dan Green, an 18-year mortgage industry veteran and founder of the Mortgage Media Publication. and real estate The Mortgage Reports, and current CEO. from the Homebuyer.com mortgage lender. The lower your mortgage rate, the less interest you will pay over the life of your loan. Even a small rate reduction can lead to savings of thousands of dollars.
What is the amount of a typical down payment?
Even though there is a rule of thumb that revolves around a 20% down payment, experts we spoke to say most homebuyers don’t save as much for a down payment. “Having a 20% down payment is great, but not if it wipes out your savings, leaving you with nothing to run a household or plan for emergencies,” Arevalo says.
The average drop for all borrowers is around 12%, says Valdes, citing data from the National Association of Realtors. Green breaks it down further, noting that first-time homebuyers often pay 7%, and active-duty military homebuyers often save 4% for a down payment.
“The size of down payments doesn’t match the performance of homebuyers,” says Green. “Good real estate agents and lenders know this. “
Why getting a loan for a down payment is a bad idea
Even with lower down payment requirements, it can still be difficult for first-time home buyers to find the cash up front. The median price of homes in the United States in the third quarter of 2021 was $ 404,700, according to the Federal Reserve in St. Louis. Following the 20% rule of thumb would require a down payment of just over $ 80,000. Even with a 3% down payment, you would need to save over $ 12,000 to buy a home.
Experts warn against the temptation to take on more debt just to walk into a home. “Incurring a new loan payment on top of the new mortgage payment could stretch the household budget even further, which is never a good idea,” says Arevalo.
Not only do experts advise against this move, but it’s not a widely available option anyway. Typically, you can’t get a loan for a down payment, ”says Valdes. Most unsecured personal lenders prohibit their loans from being used for real estate, and most secured loans – like home equity loans or HELOCs – require that you already have a home that you can put as collateral.
Another factor to consider is whether your mortgage lender allows you to use a loan for your down payment. “If you get a down payment loan, it’s not a down payment, it’s a loan,” says Green. “Loans are allowed, but they must be disclosed as part of your mortgage application,” he adds.
Check with your lender about state or local down payment assistance programs. You may be eligible for grants or special programs that lower the cost of the down payment, especially if you are a first-time home buyer or low income.
Alternative down payment options
The reason many financial experts recommend a 20% reduction is because it means avoiding mortgage insurance, getting a better interest rate, paying less interest on the loan balance, and paying off the loan. earlier. But that’s not always necessary, according to Green, Valdes and Arevalo. “There are many mortgage products that cater to less traditional home buyers and those often challenged by old standards,” says Arevalo.
Government guaranteed loan
If you don’t have 20%, look at government-backed programs that have lower down payment requirements. An FHA loan only requires 3.5% down payment, and it is possible to get a USDA or VA loan without making a down payment at all. Even conventional mortgages can have lower down payments. For example, Fannie Mae’s HomeReady program only requires a 3% down payment. Keep in mind that some of these programs may have restrictions that limit who can qualify.
Down payment assistance programs
Homeowners may be better off looking for other forms of down payment assistance. Valdes suggests checking out state and local down payment assistance programs, especially those for first-time home buyers. “Ask your loan officer what programs are specific to your area,” she advises.
Green points to a program called Chenoa that provides repayable loans for the down payment as part of home buying assistance. “FHA loans allow for second mortgages like the Chenoa program,” he says.
Arevalo suggests finding a HUD-approved housing advisor for free advice on buying a home, check your local housing finance agency (HFA) site or a database called the Down Payment Resource. .
Finally, some mortgage programs, like FHA loans, also allow you to offer down payments, explains Valdes. If you have friends or family willing to help, they may be able to help you fund your down payment. You can also use funds offered by loved ones to cover closing costs, she adds.
It is important to review the requirements to be eligible for these programs. USDA loans have income and location restrictions, and VA loans are only available to eligible military, veterans, and surviving spouses.
How to save for a down payment
If you are not eligible for any assistance program, it is better to wait and save before taking out a loan to cover the down payment. Valdes has a few tips for finding the extra money to spend on buying a home:
- Pre-qualify to find out how much home you can afford and an exact down payment you can start saving for.
- Ask your loan officer what no-down loan you may be eligible for.
- Use your tax refund as a down payment on a new home.
- Take out the extra services including gym, Hulu, other subscription services, and put that money aside for the future.
- Consider getting a home or condo starting now, so you can build equity and trade it in later.
Don’t spend too much time trying to hit what could be a moving target when trying to save for a fixed percentage for your down payment, suggests Green. Rather than sticking to a specific percentage, whether it’s 20%, 10%, or 3%, it might make more sense to put aside as much as possible and then look at loan programs. for down payment and help. If you have good credit and a reliable income, Green points out, you can probably find a lender who is willing to work with you and help you find a program that can help you meet your homeownership goals.