Navigating the down payment portion of any home purchase can be a daunting task. Among first time homebuyers, in particular, there is a misperception that unless you are financially equipped to put 20% of a home’s sticker price on the table at closing, you are out of luck. While 20% down does offer a helpful reference as you consider whether or not you are ready to start shopping around, it’s important to understand where your down payment fits into the overall transaction. This will better enable you to develop a down payment strategy that best supports your budget and personal financial goals.
Down payment requirements range widely based on your unique credit profile and available assets, the market in which you are interested and your potential lender. In the case of a conventional loan, lenders typically require that you put down anywhere from 5 to 20%. Let’s say you were looking to buy a home that cost $200,000. (The median home price in the U.S. as of January 2016 was $213,800, according to the National Association of Realtors.) A 5% down payment would be $10,000, versus $40,000 if you opted to put down 20%.
While you may be able to purchase a home by making a down payment at either end of the spectrum, the difference between 5 and 20% can have a long-term impact on how much you pay in interest on your mortgage and the additional fees that will be associated with your home purchase.
The area where you will see the largest difference in the lifetime cost of your mortgage when you opt for a lower down payment is the interest rate. Typically, the smaller your down payment, the higher your mortgage rate. Even a few basis points can make a big difference over a 30 year mortgage, so it is important to evaluate how much a lower down payment may be worth now if it means thousands of dollars more in interest later.
With regard to additional fees at closing, in most cases, a lower down payment can lead to a larger closing fee. (These fees are normally between 2 and 5% of the home’s value and are on top of your down payment.) Additionally, if you put less than 20% down, you’ll in most cases be required to purchase what’s called private mortgage insurance (PMI). Under a PMI policy, you pay a premium each month in addition to your mortgage. You’ll need to maintain a PMI plan at least until your loan-to-value (LTV) ratio reaches 80%. On some lending products, your lender may cancel your PMI policy at 80% LTV and must cancel the policy at 78% LTV. With other types of mortgages, you may need to maintain your PMI policy for the duration of your mortgage.
For those who are newer to the housing market, your LTV is the amount you owe on your home versus the home’s total value at closing. For example, if you make a down payment of 20%, your starting LTV would be 80%. A down payment of 5% would make for an LTV of 95%. LTVs are like golf – the lower the number, the better both for you and your lender.
While we’ve primarily focused on the options that exist for homebuyers who can afford a 5 to 20% down payment, there are programs that help families for whom a 5% down payment would create undue financial hardship. Many states and local municipalities maintain lending programs that address lower income borrowers and offer more options in terms of down payment. The Federal Housing Administration’s FHA loan program offers mortgages with down payments of just 3.5% to qualified borrowers. Veterans Affairs (VA) and the U.S. Department of Agriculture (USDA) also both offer zero down payment programs for veterans and families living in rural areas, respectively.
As you consider buying a home, the most important thing you can do is start speaking with your mortgage expert early. This will better enable you to figure out the most effective strategy for you – from down payment to closing costs, and all the other terms that are factored into your mortgage.