– Donna Fuscaldo – Contributor – Forbes
Everyone knows they need a down payment to purchase a home. But how big of a down payment should you make?
The average price for a newly built home as of the end of stood at $318,600 at the end of 2018. A 20% down payment would require the buyer to put down $63,720. With a 5% down payment that declines to $15,930, more palatable to many would-be home buyers. In fact, the average down payment for first-time buyers was 5% in 2017, down from 6% the year earlier.
There are ramifications for putting less than 20% down on your home purchase. Before you can determine how much you should offer up you have to understand the implications it will have over the life of your loan.
There are several factors to consider when planning for a down payment on a home:
- Loan Type: Different home loan programs require different down payments.
- PMI: For down payments of less than 20%, a borrower must pay for Private Mortgage Insurance.
- Interest Rate: The size of the down payment can affect the loan’s interest rate.
- Savings & Budget: A larger down payment of course requires more cash at closing. It also lowers the monthly mortgage payment as it reduces the amount borrowed.
Type of Mortgage Programs
There are many mortgage programs. Three of the most popular mortgages are a Conventional Mortgage, FHA Mortgage, and a VA Mortgage. Each has different down payment requirements.
A conventional mortgage is not backed by the government. According to the U.S. Census Bureau as of the first quarter of 2018, conventional mortgages accounted for 73.8% of all home sales in the U.S. With a conventional mortgage, if you don’t come up with a 20% down payment, you should expect to pay PMI insurance (Private Mortgage Insurance) – which protects the lender, not you. (More on PMI, below)
According to the Consumer Financial Protection Bureau, conventional loans with down payments as small as 3% may be available. There are downsides to a low down payment conventional mortgage. In addition to paying PMI, your monthly payment will be higher and your mortgage rate could be higher. In addition, you will have equity cushion; should housing prices fall, you could end owing more than the house is worth. (That’s known as being “upside down” on a mortgage, and can create problems if, for example, you need to sell your house and move.)
Open only to veterans and active duty military personnel, the VA loan is a mortgage that is backed by the Department of Veteran Affairs, enabling lenders to provide mortgages to our nation’s military and qualifying spouses.
One of the biggest benefits of a VA mortgage is that there is no down payment requirement to purchase a home, so long as the price you are paying doesn’t exceed the appraised value of the home. There is also no PMI required with the loan. The lenders do engage in the underwriting of these mortgages, which means you should have a credit score of 620 or more, verifiable income and proof that you are veteran or active military personnel.
The most common government-backed program is the Federal Housing Authority or FHA mortgage. FHA mortgages, which are loans that are insured by the government, have been around since the 1930s when the program was first instituted to combat foreclosures and mortgage defaults.
Borrowers with a credit score of 580 or more are required to put just 3.5% down but will pay PMI insurance if it is under the 20% threshold. Borrowers with a credit score between 500 and 579 could still be eligible for an FHA mortgage but would need to pony up a 10% down payment. Lenders are able to be less stringent when evaluating the creditworthiness of the borrower because if the loan goes into default the government is on the hook.
The size of your down payment will also dictate if you have to pay private mortgage insurance. Private mortgage insurance, otherwise known as PMI, is mortgage insurance that borrowers with a down payment of less than 20% are required to pay if they have a conventional mortgage loan. It’s also required with other mortgage programs, such as FHA loans. PMI protects the lender, not the homeowner, in the event the borrower can’t make good on a mortgage.
Traditionally, the cost of PMI was added to a borrower’s monthly mortgage payment. When the loan balance fell below 80% of the home’s value, PMI was no longer required. Today, borrowers may have other options.
For example, some lenders allow borrowers to have the monthly PMI premium added to their mortgage payment, cover it via a one-time upfront payment at closing or a combination of an upfront payment and the balance incorporated into the monthly mortgage payment. Lenders will also offer lender paid PMI in which you agree to pay a slightly higher interest rate on the mortgage loan to compensate for not paying for the private mortgage insurance. The interest rate for lender paid PMI is typically a quarter or half of one percent more.
In a low-interest rate environment, lender paid PMI may make sense. With the Federal Reserve raising rates and more expected to come, however, it may end up being the costlier choice. Mortgage insurance premiums typically range from 0.5% to as high as 5% of the mortgage loan.
Not putting 20% down can result in more than having to pay monthly PMI. It could impact the interest rate on your mortgage, according to the CFPB. Some lenders reward borrowers for higher down payments in the form of a lower interest rate. Mortgage lenders typically use risk-based pricing when determining the interest rate on a loan. If they perceive more risk they charge a higher interest rate. Less risk, a lower rate.
If you provide more than a 20% down payment it sends a signal you can afford the mortgage and thus are less likely to default, leaving the lender on the hook with the property. That can be a huge saving given you are likely to pay your mortgage for three decades. Saving even 0.25% in interest can have a meaningful impact over the years.
Size Of Down Payment Depends On Cash Flow, Location
When it comes to determining how much down payment you plan to offer up, your cash flow and savings are going to dictate a lot of the decision making. Twenty percent down is the way to avoid PMI. If you can’t amass that much of a down payment, a smaller down payment can mean the difference between home ownership and renting.
A lower down payment also frees up cash for repairs or monthly expenses once you become a homeowner. Some first-time buyers go through a bit of sticker shock when they become homeowners, faced with higher monthly bills and the need to maintain or repair their new home. To prevent that, some opt for a lower down payment.
For home buyers who are in the position to put the 20% down, it still may not make sense if they are using money that is earning interest in an investment or savings account. By keeping the down payment under 20% they don’t have to tap their savings or invested money and as a result, are preserving their interest earnings investments. They won’t lose the positive benefits of compounding either, which happens when the earnings from an investment are reinvested.
On the flip side, that 20% down payment may be necessary if you are shopping in a highly sought after neighborhood. With price wars still breaking out in pockets of the U.S. the bigger the down payment the stronger your offer will appear to sellers. After all, no one wants to agree to a sale price only to find out the would-be buyer isn’t eligible for the mortgage. A large down payment is a sign of strength and commitment to the sale process.
A 20% down payment has long been the standard when it comes to mortgages but countless people are putting down a lot less. Whether or not it makes sense for you depends on the location of the property, your financial position and your feelings toward mortgage insurance.