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Deciding On Your Down Payment

mortgage fact down payment on a house
Good news: You have options for finding the down payment money for your dream home.

There are two words that can strike fear into the heart of any prospective homebuyer: down payment. A recent Trulia study reveals it’s one of the reasons many people spend the better part of their lives as renters instead of becoming homeowners, with 42% of renters saying the down payment is still the biggest obstacle. But there are many ways to approach — and accomplish — this savings feat.

If saving enough to meet the 20% down payment threshold feels as daunting as running a marathon, take heart. Although a down payment of 20% is ideal — and required for some loans — there are loans out there that don’t require such a big chunk paid upfront. “Many people make the mistake of thinking that they have to make at least a 20% down payment in order to qualify for a mortgage,” says Todd Sheinin, a mortgage lender and chief operating officer at New America Financial in Gaithersburg, MD. If that were the case, 60% of would-be homebuyers wouldn’t be able to get a loan, according to a report by the Center for Responsible Lending at the University of North Carolina.

Granted, depending on where you live, a down payment that size may or may not put you in the position to purchase a home. After all, in some markets, saving a down payment can take decades. In Washington, DC, for example, where the median home sales price hovers around $550,000, a 14% down payment would be $77,000. But in a housing market like Raleigh, NC, where the median sales price is around $202,000, a 14% down payment costs only $28,280.

Have little (or no) cash in the bank for a down payment? There are still loans out there for you. You may be able to qualify for a Department of Veterans Affairs (VA) loan or a Federal Housing Administration (FHA) loan, which lets buyers make down payments as low as 0% and 3.5%, respectively. There are also two new home loan types that allow for down payments as low as 3%: the HomeReady™ mortgage and the Conventional 97 mortgage. However, if you’re eligible only for conventional financing, you’ll probably want to accrue enough cash to afford at least a 10% down payment, says Sheinin. (With only a 5% down payment, you may still be eligible for a loan, but the terms probably won’t be as favorable.)

Here are some easy ways to start saving:

  • Assess your spending habits. Look at your bank statements from the last three months and see where your money is going, then identify spots where you can cut back.
  • Make small lifestyle changes. You can save money in some relatively painless ways. Using couponing mobile apps like Grocery iQ, Coupon Sherpa, and SnipSnap, for example, can help cut costs.
  • Negotiate better rates. Your internet and cable bills aren’t set in stone. Contact your service provider and ask for price reductions. If you get pushback, say that you’re considering canceling your subscription and see if the company offers you a deal. (Of course, be polite to the customer service representative while doing so.)
  • Make it more difficult to spend. Do a lot of impulse shopping? Studies have shown consumers spend significantly more when they shop using credit cards, so go on a cash-only spending diet.
  • Automate your savings. To resist the temptation to spend your full paycheck, set up automatic monthly contributions to your employer’s sponsored 401(k) or a designated savings account.

Should I wait to buy a house until I have enough cash for a 20% down payment?

Not necessarily. You need to determine what the best down payment amount is for you — and we’re sorry to report there’s no one-size-fits-all percentage. But let’s look at the benefits of making that magical 20% down payment when using conventional financing.

From an affordability standpoint, a larger down payment means a smaller monthly mortgage payment, potentially lower interest rates, and no private mortgage insurance (PMI) or mortgage insurance premium (MIP) payments. If you can’t afford to put down 20%, you’ll likely have to pay some form of mortgage insurance, a type of insurance that protects the lender in case a borrower defaults on the loan. The institution underwriting the mortgage handles the insurance, but the borrower pays the premium.

What size premium are you looking at? The cost varies based on the size of your down payment and your credit score, but mortgage insurance can range anywhere from 0.05% to 1% of the total loan amount. Thus, assuming a 1% MIP or PMI rate on a $200,000 loan with no down payment, you’d be required to fork over an additional $167 every month. Ouch.

When your loan balance reaches 80% (meaning you’ve paid 20% of your loan over time), you can request to cancel your PMI or MIP. You must request the cancellation in writing and have a solid payment history; some lenders require homeowners to send in documentation and get a formal home appraisal before they’ll remove the fee. If you don’t take this step to cancel, once you’ve reached 78% of the loan amount, as long as your payments are up to date, your lender must automatically cancel your PMI or MIP.

So the question remains: Should you wait until you can afford to make a 20% down payment to buy a home? It may boil down to whether owning a home would help you save money. If you’re paying $2,000 a month to live in an apartment but can qualify for a mortgage and purchase a home where your monthly payment would be $1,400, for example, it may be worth buying now and paying that mortgage insurance fee. Plus, you’ll gain equity in the home rather than sending your rent money down the drain. Use Trulia’s rent vs. buy calculator to get a rough idea of how much you’d save, then meet with a lender to discuss your options.

Can I put down less than 20% and avoid PMI?

There is a financing option that lets you skirt PMI with a smaller down payment: have the lender cover the costs. The tradeoff? If your lender eats the insurance, you’ll probably get a higher interest rate, which could increase how much money you pay in interest over the life of the loan. However, the move might make sense depending on the size of your down payment and how long you plan to stay in the home; have your loan officer run the numbers so you can survey your options.

Does it make sense to put down more than 20%?

It depends on the size of the loan, says Sylvia Gutierrez, a loan officer in South Florida and author of Mortgage Matters: Demystifying the Loan Approval Maze. “Generally with a [conventional loan] that’s below $417,000, there’s no difference in pricing between a 20% down payment and a higher down payment,” says Gutierrez, adding that $417,000 is the cutoff point for whether a mortgage qualifies as a jumbo loan. “With jumbo loans, the break point is typically 25%,” she says. In other words, putting a 25% down payment on a $417,000 loan could get you a better interest rate.

Should I dip into my retirement savings accounts to afford a down payment?

You could face substantial consequences for tapping designated retirement accounts prematurely. Although first-time buyers can withdraw up to $10,000 for a down payment without a tax penalty, in other cases, if you borrow from a 401(k) or individual retirement account before age 59.5, you’ll get hit with a 10% excise tax on the amount you withdraw, on top of paying the regular income tax on withdrawals from traditional defined contribution plans. This can be a slippery slope — if you get into the habit of taking money from your retirement accounts whenever you need extra cash, you probably won’t be retiring at 65 years old. Consequently, it may make sense to hold off on buying for a few years and save money instead of raiding the retirement piggy bank.

What if I’m using a monetary gift for my down payment?

Most mortgage lenders will allow you to use gifts from relatives as a means of funding your down payment. However, you may be subject to a 10% gift tax on the money depending on how much you received, and you’ll have extra paperwork to submit that proves the money is a gift and not a loan.

Under the Internal Revenue Service’s gift tax exclusion rules, an individual can give up to $14,000 to another person each year without triggering a gift tax. Therefore, two parents could give up to $28,000 to help their child purchase a home; if the child is married, the parents could also gift $28,000 to their son or daughter’s spouse — effectively giving them $56,000 for a down payment without incurring a gift tax. (They’d also be incredibly generous parents!)

How much cash do I need to cover closing costs?

Unfortunately, there’s a common misconception that closing costs are always a fixed percentage of the loan amount. “It’s not that simple,” says Gutierrez. “There is no general rule of thumb saying that closing costs are always 2% of the loan amount.”

Costs can vary significantly based on the size of the loan and what company you choose to oversee the closing. Typically, the buyer selects the title company, which essentially acts as a third party in the sense that it does not represent the buyer or the seller. Think of the title company as a shared divorce attorney that’s helping both parties reach an agreement. In the case of purchasing a home, the title company’s role is to confirm the home’s title — which the seller is transferring to the buyer — is legitimate, and to issue title insurance for the property.

This process can sometimes be complicated if the title company discovers problems that question who the rightful owner of the property is. Potential issues include any outstanding mortgages, liens, judgments, or unpaid taxes on the property, as well as any restrictions or easements. The title company is also typically responsible for controlling the funds involved with the purchase — commonly holding the buyer’s earnest money deposit in an escrow account — and ultimately disbursing the funds at settlement.

The estimated cost of title services and title insurance varies by state. (In some states, the price can even vary by county.) And like mortgage lenders, some title companies charge higher fees than others, so it pays to shop around and compare rates before choosing which one you want to use.

Have your down payment decided? Great! Time to make a decision on what type of loan to go with.