Even first-time homebuyers who don’t know much about real estate know about the ominous down payment.
Most consider this to be one of, if not the biggest financial hurdle to owning your own home. However, the down payment is a lot more than just a lump sum payment that destroys your savings account balance.
Deciding how much of a down payment you can afford has a direct impact on what price of house you can afford. As a homebuyer, you need to know about down payment options and amounts before you begin looking at houses, because it will dictate the types of houses you look at in your home search.
If you don’t think about it until you’ve already fallen in love with a specific house, you could be in for some really tough financial decisions.
Due to its role in determining how much house you can afford, it’s important to understand what the rules and guidelines of making down payments are and what situational factors you need to evaluate in order to make the right down payment on your future home.
In the most basic terms, a down payment is an amount of money you give up front when purchasing a home to secure your purchase.
The typical, “conventional wisdom” amount for a down payment is 20% of your overall purchase price. That means if you're buying a house that costs $300,000 total, your down payment would be $60,000. Whatever remains to be paid after you make your down payment is then covered by your mortgage loan, which you pay back on a monthly basis throughout the term of your mortgage.
However, despite the fact that most people think of 20% as a usual down payment, this can differ based on your specific situation and your mortgage type. (See more about how down payments differ by loan type below.)
Unfortunately, there is no perfect down payment number that fits every person and every situation. The right answer for you will be determined by a number of factors and, primarily, how much you can afford to put down at that time.
Here are the main reasons why a downpayment is useful:
The higher the percentage of a down payment you make, the less you pay for the rest of your home. You don't pay interest on the down payment, as you pay it right away. This means that the larger your down payment is, the lower the remaining amount on which you do have to pay interest.
Lenders are likely to give you a lower interest rate on your loan. A higher down-payment is a sign of financial stability. This makes you look good to lenders, who are then more likely to loan you money as you are a low risk of failing to make your monthly payments.
If you pay over 20% for your down payment, you don't have to pay PMI (aka Private Mortgage Insurance). We will cover PMI in a later section, but it's basically an extra safeguard lenders put in place for people who make a down payment lower than 20%.
If you are competing for other buyers for the home, a larger down payment gives you more leverage with the seller. When deciding between two potential buyers, a seller is likely to go with the buyer who is most likely to get a loan. (If the buyers loan falls through, the seller has to start all over and find a new buyer, which no one wants to do.) This means that putting down more than 20% for a downpayment makes you a more attractive buyer to sellers.
As is the case with most things in real estate, the answer to this question depends on your specific situation. As described in Maximum Real Estate Exposure’s guide for first time home buyers, there are many costs, variables, and factors that must be considered when it comes to the financial side of home ownership.
Some of the factors which could affect your ideal down payment amount include:
Your credit score
How much money you have saved up
Your current income
What other uses you have for your saved money
The price of the house you are trying to buy
The type of loan you get
While everyone seems to think that 20% is the rule of thumb, the average down payment is slightly lower than that. In 2016, the average down payment for a house was 11%.
Way to calculate what down payment would be most beneficial in your personal circumstances is to use a mortgage calculator. There are many mortgage calculators available for free online. All you have to do is type in your specifics and you can see the different financial scenarios for different down payment amounts.
Private mortgage insurance is an extra protection for lenders (i.e. the bank or whoever is providing your mortgage loan) in case you default on your loan. This is usually between 0.5% and 1% of your total mortgage amount.
You usually have to pay PMI if you can't make it down payment of at least 20%, just as a little extra protection for them. Your PMI amount is paid alongside your normal mortgage.
Fortunately, PMI does not have to be paid for the entire length of your mortgage. Usually, once you get enough of your mortgage paid off, typically what would have amounted to a 20% initial down payment, you can contact your lender and try to get your PMI payment removed.
Getting PMI removed can sometimes be complicated, so it's best to avoid PMI whenever you can. If you do have to pay it for a while it isn’t the end of the world, but make sure you factor your PMI amount in with your regular mortgage payments when calculating how much you can afford.
When people say a ”conventional mortgage”, what they're referring to is a traditional 30-year fixed-rate mortgage.
(Basically, this means that you will make payments for a period of 30 years to pay the amount not covered by your down payment, plus whatever interest is accrued during that period of time.)
For conventional mortgage, the minimum down payment is usually 5%. However, as mentioned above, you might have to pay PMI if you make a down payment of less than 20%.
An FHA loan is a home loan which is backed by the Federal Housing Administration (FHA). These loans are popular, especially among people who are buying their first home, because the minimum down payment is 3.5% instead of a conventional mortgage is 5%.
However, minimum credit score for an FHA loan is 580, if a buyer has a credit score between 500 and 579, they can still get an FHA loan by paying 10% down.
There are also other differences between loan types. For instance, on an FHA loan you can remove PMI after 11 years as long as you have put more than 10% down on your home. On a conventional mortgage, you can only usually remove PMI after you have paid off 20% of your loan.
This is one of many examples of how many different factors combine to determine what the right down payment is in any specific circumstance. There is no cut-and-dry answer, so talk to a realtor or a loan officer to get the right answer for your specific set of variables.
A VA loan is one of the government loan programs that provides zero money down loans for certain populations. Specifically, a VA loan is for veterans and current US military personnel. It is possible to get some VA loans with 0% money down.
Other government agencies, such as the Department of Agriculture (USDA) how's other similar loan programs for other types of people. For example, the USDA offers a zero down loan programs for certain rural areas.
This is one of the reasons why it's so important to talk to a qualified and knowledgeable loan broker. It's very hard to research what you don't know, but someone with experience in the loan field can tell you exactly what specialized loans you might qualify for.
The down payment is a very powerful tool in the buyer’s toolkit.
If you don't have money for a 20% down payment, there are still options available to you, from different loan types to various configurations of PMI. Make sure you talk to a knowledgeable lender or mortgage expert to see what you qualify for and what options are open to you.
However, just because you can avoid paying a 20% down payment doesn't mean you should. Making a 20% or more down payment on a house has numerous advantages, including more bargaining power with the seller of the house and paying less interest over time.
Do your research before you start looking at houses, get your finances in order so you know what you can comfortably afford to pay for, and make sure you talk to a qualified lender before you start house hunting.
If you go into the house hunting process with your financials in order, you will limit your search to what you can afford. There's nothing more painful than getting your heart set on a house and then realizing you can't afford it.
Above all, exercise common sense and know when to ask questions.
If you want help evaluating your specific financial situation, sign up below for a free, no commitment 15 minute call to discuss your options.