How Much Down Payment Do You Really Need to Buy a House?
A down payment is one of the biggest roadblocks for the average American looking to buy a home - but it shouldn’t be. We need to save tens of thousands of dollars in order to move into a home, right? How are we supposed to set aside that kind of money, especially as a first-time homebuyer whose paycheck is mostly going to pay rent? Many of us aren’t aware that there are programs out there to help make buying a home more affordable by lowering the down payment required. Further, most people think you need 20% of the purchase price of the home for a down payment, but that is simply not true. In fact, the average down payment in the United States is around 11% of the purchase price for second-time homebuyers and around 8% of the purchase price for first-time homebuyers. Down payment assistance programs can help lower the down payment even more. So, what is a down payment, why do you need to make one, and what are the down payment programs that are available? Let’s dive in and answer these questions.
A down payment is a “payment” that you make in order to get a loan for a house that you want to buy. The money you use as a down payment is not the bank’s money - it is still your money, but it is tied up in the property as equity. Equity is like a savings account that cannot be accessed until the property is sold (or a home equity line of credit is used). Equity in a property increases as the property value goes up and every time you make a payment towards the loan. Almost all lenders require a down payment because it provides them with a cushion should property values decrease and you stop making payments on the loan. Banks would always prefer that you make a larger down payment because it makes this cushion for them bigger, meaning the loan is less risky for the bank. By reducing the risk for the bank through making a larger down payment, they often reward you with a lower interest rate - which translates to lower monthly payments.
Now to crush a common myth: You need to have at least 20% of the purchase price of the home as a down payment. As I mentioned previously, this is not true and most people don’t end up putting 20% down. If you put less than 20% down on a home you will pay something called private mortgage insurance (PMI), which is a small fee you pay every month to compensate the lender for taking on more risk due to a lower down payment. In fact, there are several programs (FHA, VA, & USDA being the most common) that allow you to purchase a home with a down payment of much less than 20%. Let’s discuss these programs in more depth.
FHA Loans
An FHA loan is a loan made by an FHA-approved lender and is also insured by the FHA (Federal Housing Agency). This type of loan is targeted to low-to-medium income borrowers. With this type of loan you can borrow up to 96.5% of the value of a home (meaning a down payment of as low as 3.5%), but you’ll need a high enough credit score. If your credit score is lower than the required score for a 3.5% down payment, you can always pay a higher down payment and still get an FHA loan. Key features or things to know about an FHA loan can be see below:
Down payments as low as 3.5%, if you meet credit score requirements (at least 580)
This is the go-to program for many first-time home buyers with lower credit scores.
The FHA will insure loans for borrowers with scores as low as 500 but may require a 10% down payment for a score that low.
Mortgage insurance premium (MIP) is required for the life of an FHA loan. This is an additional monthly fee that you’ll pay every month and is essentially the same thing as private mortgage insurance (PMI) that you will be required to pay if you don’t put 20% down on a conventional loan
VA Loans
A VA loan is a loan that is available to veterans and active duty service members that qualify. These loans allow the homebuyer to purchase a home with no down payment at all, and is backed by the U.S. Department of Veterans Affair (VA). This means the government has agreed to repay a portion of the loan to the bank if you don’t make your payments, making this type of loan less risky to a bank. In order to get this loan, you must meet the VA’s specific service requirements. Generally, you’re eligible if you fall into one of these three categories:
You’re an active duty service member or an honorably discharged veteran who has 90 consecutive days of active service during wartime or 181 days of active service during peacetime
You have served more than six years in the National Guard or the Selected Reserve
You’re the spouse of a service member who died in the line of duty
In order to apply for a VA loan, you need to get a Certificate of Eligibility (COE), which is a document that shows lenders that you qualify for a VA loan up to a certain dollar amount. You can apply for a COE through the VA website, by mail, or through your lender.
VA loan key features can be seen below:
Must be a military member, veteran, surviving spouse
No minimum credit score
No down payment in some cases
No mortgage insurance required
Likely have to pay a one-time VA funding fee. This fee can be included in the loan amount so that it is paid off monthly when you make your regular loan payments
Guaranteed by the U.S. Department of Veterans Affair
USDA Loans
A USDA home loan is a zero down payment mortgage for eligible rural and suburban homebuyers. They are issued through the USDA loan program, and backed by the United States Department of Agriculture. This results in a lower-risk loan for banks as the USDA takes on some of the risk of someone defaulting on the loan. There are a lot of potential requirements in order to qualify for these loans, so it is best to consult with a lender to help you understand if you qualify for this loan type. Some key features about USDA loans can be seen below:
No down payment
Only eligible to rural and suburban home buyers. Metropolitan areas are generally excluded from this program.
There are income limitations in order to qualify
Credit score is taken into account to qualify. A higher credit score may help you in some cases
Issued by the U.S. Department of Agriculture through the USDA Rural Development Guaranteed Housing Loan Program
Conventional Loans
A conventional mortgage or conventional loan is any type of home buyer’s loan that is not offered or secured by a government entity, such as the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA), or the USDA. The loans are instead secured by individual banks, lenders, Fannie Mae, or Freddie Mac. In order for the loan to be guaranteed by Fannie Mae and Freddie Mac, it must meet strict requirements (called a conforming loan). If the loan doesn’t meet those requirements the loan is secured by the lender itself, making it riskier to the lender. Most people can qualify for a conventional loan, but may be required to assume different interest rates and down payment requirements depending on their income and credit score. It’s always best to consult with a lender to determine which loans you can qualify for. Some key features about conventional loans can be seen below:
First-time home buyers can get a conventional home loan with as little as 3% down if the mortgage meets requirements set by Fannie Mae and Freddie Mac.
Will be required to pay PMI (private mortgage insurance) if down payment is less than 20%
Most lenders require a minimum credit score of 620 to qualify for a conventional mortgage, but a score around 740 earns you the best interest rates
When it comes down to it, saving for a down payment shouldn’t be as scary as it sounds. Now that you know what potential options are available, it’s important to start making a plan to help get you in a financial situation you feel comfortable with in order to purchase a home. Oh, and one last thing - the great thing about a down payment is that you may only need to save for one once. Here’s what I mean by that: when you make a down payment on your first home, that money is yours when you sell the house to purchase another. This means that if the property value for your home increases (which is very likely), you’ll have access to your original down payment (and other equity you have in the home) money to use as a down payment when you purchase your next home. So, once you have your down payment money saved it may be the last time you ever have to worry about it!
Give me a call if you or someone you know wants to learn more about the options available to help you purchase a home. I’m more than happy to connect you with a qualified lender and work with you to see how I can help begin the process of finding you your dream home.