Saving enough money for down payment is among the first items on the list when purchasing a new home. The amount of down payment required depends on which type of mortgage you choose. Most lenders require between 10 and 20 percent of the home’s value up front to approve a home loan.
Down payment represents the initial equity, or ownership stake, in the property. If a family provides $20,000 to purchase a $200,000 home, then their initial equity will be 10 percent. This equity will grow with each mortgage payment.
If you are unable to save for down payment, or prefer to put less money up front, there are alternatives. For example, the federal government sponsors a variety of mortgage programs which accept lower down payments. In this article we provide guidance to help determine how much down payment to make.
What are the benefits of down payment?
Not all mortgage loans require 20 percent down payment. There are alternatives for families who don’t have enough money saved or prefer to start with less equity. Each of these alternatives comes with their own benefits and drawbacks.
The first option is FHA loans, which are mortgages backed by the U.S. government. These loans are offered by financial institutions which have been approved by the Federal Housing Administration, or FHA. These loans are quite popular among first-time home buyers because of lower requirements. People can qualify for an FHA loan with credit scores as low as 500, giving only 10 percent down payment.
If their scores are above 580, down payment can be as low as 3.5 percent instead. This means someone can purchase a $100,000 home with only $3,500 in hand. Although lenders have to finance the remaining 90 to 96.5 percent, FHA loans have low single-digit interest rates because of government backing. However, in recent years, lenders have been issuing hybrid FHA loans, which start with a fixed-rate and after a few years switch to adjustable rates.
Fannie Mae and Freddie Mac, the two government-sponsored enterprises which help maintain stability in the mortgage market, also offer home loans requiring as little as 3 percent down payment. Several big and small lenders have also started offering low down payment mortgages to stimulate borrowing. In recent years, homebuyers with good enough credit scores have been approved for home loans with less than 3% down payment.
People who currently serve, or have previously served in any branch of the military, have access to special VA loans offered by the Department of Veteran Affairs. These loans have very generous interest rates, flexible requirements and low down payment. Surviving wives of deceased veterans also have access to these loans under special conditions. Families living in rural areas can take advantage of home loans offered by the Department of Agriculture through its Rural Development program. These loans can be used to purchase homes in rural areas. Like VA loans, USDA mortgages have flexible requirements, which can include no down payment.
How to determine how much to set as down payment?
With so many options, families often ask themselves which one is better for them. Putting down 20 percent seems attractive due to lower interest rates and monthly payments. However, putting down 3 percent instead may allow a family to purchase a home right away instead of spending several more years saving for a higher down payment.
Choosing the right option requires careful consideration of several factors involving the purchase.
The first one is property value. If the target home is valued at $75,000, it may be easier to put down between $7,500 and $15,000 as down payment. However, properties with higher market values may make this task more difficult. For example, a family would have to save $40,000 to cover 20 percent down payment for a $200,000 home. In such a case, putting down 3 or 6 percent, which is between $6,000 and $12,000, might be a more realistic approach. As explained above, some government agencies approve home loans with no down payment. However, these are often given to low-income families who want to purchase home in places where houses are not expensive.
The second factor is debt-to-income ratio, which is a number that represents how much of a family’s income goes toward paying existing debt accounts. Purchasing a new home means acquiring more debt, which raises debt-to-income ratio. For example, a family earning $2,500 a month, paying $850 monthly to existing debt accounts, has a debt-to-income ratio of 34 percent. Purchasing a $75,000 house through a 30-year fixed interest rate mortgage loan would add around $350 to their monthly debt accounts, raising debt-to-income ratio to 48 percent. In general, lenders approve new loans to families whose debt-to-income ratio is below 43 percent.
Choosing a cheaper home or providing a larger down payment are two ways to keep debt-to-income ratio in check. However, a family that expects some debt accounts to be fully paid in the near future can choose to provide a lower down payment.
The third factor is risk and mortgage insurance. For most lenders, borrowers who provide low down payments are riskier than those that cover 10 or 20 percent of the home’s value. More risk means higher interest rates and additional measures taken by lenders to reduce losses. One such measure is mortgage insurance, which is paid for by borrowers and provides a guarantee against losses if a foreclosure takes place. Mortgage insurance is split in two charges, one upfront fee that must be paid when the home loan is approved, and an ongoing charge added to monthly mortgage payments.
Mortgage insurance rates range from 0.3 to 1.5 percent of the principal balance per year. Purchasing the $75,000 home in the example above, with a 0.5 percent mortgage insurance, would raise monthly payments from $350 to $400, adding up to more than $2,100 in total. Some mortgage lenders replace insurance with an upfront guarantee fee, or funding fee, that serves the same purpose. Lower down payment means higher fees.
Purchasing a home is one of the most important financial decisions a family can make. Choosing the right down payment amount is critical to make sure monthly payments do not become a burden, lowering risk of foreclosure. However, providing too much down payment may also bring financial uncertainty if doing so means running out of savings.
The down payment is not the only upfront cost to consider when purchasing a home. Each lender manages its own set of additional fees and closing costs, which can often add up to several thousand dollars. It is recommended to shop around for the most affordable offering before settling down with a lender. After all, some other factors such as interest rates, mortgage insurance, monthly payments and refinancing terms have a much bigger impact over the long term than down payment.