Pros and Cons of a Small FHA Loan Down Payment

An FHA loan down payment can be as low as 3.5 percent, but should your strategy be to go for as low a down payment as possible? There are some good reasons for opting to make a small down payment, though you should also be aware of the potential costs of this approach.

Benefits of a Small FHA Loan Down Payment

Here are some benefits of minimizing your down payment on an FHA loan:

  1. Capture mortgage rates while they are low. The past few years have seen historically low mortgage rates, but no one can predict how long they will last. Taking longer to save up for a larger down payment could prove to be expensive if it means missing this low mortgage rate opportunity.
  2. Get into the housing market sooner. Home prices have their ups and downs, but generally speaking they have moved higher over time. Getting into the market sooner via a smaller down payment can help you eliminate the risk of being priced out of owning a home.
  3. Pay yourself rather than your landlord. The sooner you buy a home, the sooner your monthly payments will be going towards a mortgage rather than towards rent. Since a portion of those mortgage payments will contribute to building equity in the home, you will effectively be paying yourself rather than continuing to enrich your landlord.
  4. Maintain some financial flexibility. Owning a home is often more expensive than people anticipate, and it is wise to have a reserve in case of emergencies. Rather than putting every penny of savings into your down payment, holding some back in reserve can help you deal with unexpected expenses without being in jeopardy of missing a mortgage payment.

Costs of a Small FHA Loan Down Payment

Good financial decision making entails weighing the benefits of a given course of action against its costs. While the above are all valid points in favor of a small down payment, you should also be aware of the costs:

  1. Private mortgage insurance. FHA loans entail private mortgage insurance (PMI), which protects the lender against the risk of borrower default. The cost of this insurance is greater if you borrow more than 95 percent of the value of your home (i.e., if you make less than a 5 percent net down payment). So, making a little bit of a larger down payment can reduce the cost of PMI, and a large down payment could allow you to consider non-FHA options that wouldn't entail PMI at all.
  2. More interest expense over time. The more you borrow, the more interest you pay over the life of the loan. Put the cost of a smaller down payment in perspective by looking at an amortization table to see what your total interest expense will be. Compare this with what that total expense would be if you made a larger down payment.
  3. Less refinancing flexibility. The bigger the down payment you make, the more of an equity cushion you have against fluctuations in home prices. That equity cushion could prove crucial should you want to refinance in the future, either to take advantage of a drop in interest rates or simply to restructure your loan payments.

A hybrid approach could be to make a small down payment to get into a home, but then make extra payments on the mortgage with the goal of building up to 20 percent equity as quickly as possible. This would reduce your total interest expense while also creating refinancing options that could include eliminating the PMI premiums.

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