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Borrowing Money for a Down Payment

borrowing money for down payment

Borrowing funds for a down payment may feel like the only way to achieve your goal of home ownership. Coming up with a sufficient down payment is easily the most challenging part of the process, especially if you’re aiming to put down at least 20% to avoid the additional expense of private mortgage insurance.

On a median priced home today of $312,000, a 20% payment would be more than $62,000. Throw in the costs of closing, such as attorney fees, escrow and other obligations, and you could see your upfront expenses soar even higher.

Even if you qualified for a low down payment loan option such as an FHA loan, which requires as little as 3.5% down, you’d still have to shell out more than $10,000 for the down payment.

Before you decide to borrow money for your down payment, it’s important to weigh your options carefully. In this guide, we’ll go over a handful of borrowing methods and the pros and cons of each.

Borrow against equity you have in another property

One option to find the funds you need for a new home is to borrow against the equity you have in your current property. You can accomplish this through home equity line of credit or a home equity loan. When using home equity loan or HELOC for a down payment on a new home, the idea is to pay it off in full once you sell the property.

A HELOC is a revolving line of credit secured by your home. You’re given a certain amount of credit and you can draw on that credit for a certain number of years. If you don’t use all your credit, you don’t have to repay it. The draw period for a HELOC generally lasts anywhere from five to 10 years; when the draw period expires, you’ll be responsible for repaying the debt. The repayment period can be up to 20 years.
 
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Alternatively, a regular home equity loan is a loan taken out for a certain amount and repaid over a fixed number of years. It’s also secured by your home.

Pros:

  • Because the loans are secured by your home, HEL or HELOCs typically have lower interest rates than other loans.
  • The interest you pay on a HELOC or HEL is tax deductible if you use it to buy, build or substantially improve a home, under the new tax reform legislation, which went into effect in 2018.
  • If you can borrow enough for a 20% down payment, you can avoid the burden of having to pay private mortgage insurance (PMI) on the new home. What’s more, you’ll ultimately have a smaller home loan, meaning you’ll pay less in interest over time.
  • Another perk of tapping a home equity loan for a down payment is that it protects your cash savings. Should you encounter additional closing costs or unexpected pop-up expenses on the road to home ownership, it’s nice to have that safety cushion.

Cons:

  • A home equity loan is secured by your home. If you fail to make payments, the bank will initiate foreclosure.
  • While a HELOC typically has no closing costs, you’ll have to pay closing costs on a home equity loan.
  • Depending on the lender, you could potentially be hit with prepayment fees for repaying a home equity loan early. But in a competitive housing market, it may be worth it if it means getting into a great home.
  • One other risk is that selling your first home may take longer than planned. Can your monthly budget absorb two loan payments, if push comes to shove?
  • J.J. Burns, a New York-based certified financial planner, added that borrowing against your house for a new down payment can be a double-edged sword if you have a variable-rate mortgage. If interest rates rise, you could end up paying more than expected each month.

Borrow from a friend or family member

Tapping a friend or family member for your down payment is another option. Nearly three out of every four Americans have borrowed money from a family member at least once in their lives, according to a 2017 LendingTree survey.

“When you borrow money from a friend or family member, you’re signing a mortgage saying you owe somebody else money—that’s going to cost you because that’s technically a debt,” Burns said.

You may be lucky enough to have the down payment gifted to you by a friend or family member, but the amount (and who gives it) will have to meet certain requirements, depending on the type of loan you get. According to Burns, you can typically only use gifted funds that come from a blood relative. Most lenders also require a letter from the donor to move forward with an approval.

“Once the funds are gifted, the applicant will also have to provide a bank statement to confirm receipt of the gift,” Burns added. “Generally speaking, money that doesn’t have to be paid back will help borrowers in the mortgage approval process, as long as they have good credit scores and good debt-to-income ratios.”

Have your lender clarify the specific requirements for the type of loan you’re getting so that you disclose the transaction appropriately.

Pros:

  • Having a friend or family member offer to loan you the money for your down payment can very well be what gets you into your dream home.

Cons:

  • That same LendingTree survey mentioned above also found that over a quarter of those who’d borrowed from or loaned money to a family member experienced negative consequences, like hurt feelings, resentment or verbal arguments. “Relationships, we find as we get older, are significantly more valuable than transactions and numbers,” Jeanne Fisher, a Kentucky-based CFP, told LendingTree. “If somebody loves you enough to lend you money, it’s not worth jeopardizing that relationship by not being very clear about expectations upfront.”
  • Regardless of how much you end up borrowing from a friend or family member, be sure to get the agreement on paper and notarized to protect both yourself and the relationship.

Borrow from your retirement funds

Retirement funds are specifically designed to see you through your golden years, not bankroll big-ticket purchases. But if you’re stuck between a financial rock and a hard place, you could borrow a down payment from your future self.

401(k) distribution vs. 401(k) loan

Distribution: If you’re a qualified first-time homebuyer, Fisher said you can take a distribution up to $10,000 from your 401(k) or traditional IRA relatively quickly without the standard 10% early withdrawal penalty you’d otherwise incur. You’ll still be responsible for paying taxes on it, however. To qualify as a first-time homebuyer, neither you nor your spouse must have owned a primary home within the two years before purchasing the new home.

Loan: Taking out a 401(k) loan is different than taking a distribution because you will have to pay it back over time. You can repay the loan, plus interest, usually with automatic payroll deductions. The only big catch here is if you default on your payments, in which case the money you borrowed is considered a distribution, not a loan. That means you could get hit with a 10% penalty, plus you’ll be taxed on that money as if it were ordinary income.

You can borrow up to 50% of your account balance or $50,000, whichever is less, per the IRS.

One other note: The majority of 401(k) plans are structured in a way that once employment is terminated — either by quitting, getting laid off or being fired — the entire loan balance is due by the next federal tax filing deadline.

A Roth IRA is an option as well. Because you pay taxes on Roth contributions upfront, you can withdraw your funds (but not your investment gains) anytime you wish without incurring a tax penalty.

Definitely consult a financial planner or an accountant before taking a loan or a distribution.

Pros:

  • With a 401(k) loan, you’re leveraging your own money to cover the down payment, which means that you’re essentially paying yourself back with interest.
  • You can withdraw Roth IRA contributions (not your gains) whenever you like, penalty-free.
  • You can avoid the standard 10% penalty for taking a distribution from a traditional IRA or 401(k) if you’re a qualified first-time homebuyer.

Cons:

  • If you take out a 401(k) loan and then lose your job, you’ll have to repay it by the following tax filing deadline.
  • Similarly, defaulting on the loan means getting charged a 10% penalty by the IRS, plus you’ll be taxed on the remaining balance.
  • 401(k)s aside, borrowing from any type of retirement fund also means that you’re robbing yourself of future returns. “Even if you get a low interest rate, you’re likely underperforming the long-term returns that are possible in a 401(k),” said Fisher. “I’ve also found that the more people tap their retirement savings for things they want now, like a house, the more it becomes habit, which is a dangerous.” Fisher added that paying the loan back can also slow down your savings rate. “While paying back a loan, a lot of people end up reducing or stopping their contributions.”

Borrow using a personal loan

Personal loans can be used for any number of reasons, from seeing you through an unexpected financial emergency to consolidating debt. Once you’re approved, you receive the money as a clean, lump sum that you can usually use for whatever purpose you like.

That said, using a personal loan for a down payment is pretty unconventional. When you apply for a home loan, two things are paramount: your income and your debt. Both provide reassurance that you’ll be able to make good on your mortgage payments. Lenders see excessive debt as something that eats into your income, making you a potentially risky borrower.

If your total debt payments exceed 43% of your total income, it’s a red flag for mortgage lenders. On top of that, Fisher said that taking out a personal loan right before you start house hunting could impact your ability to get the best mortgage terms and rates since you’re taking on more debt.

“You’ll want to consult with your mortgage broker to make sure they understand how you’re financing the down payment,” she added.

This doesn’t mean personal loans don’t have their place in the homebuying process. If you’re carrying high-interest debt, you can use this type of financing to consolidate your existing loans. From there, you’ll be left with one monthly payment that ideally has a lower interest rate than what you were paying on your previous debt. Consolidating your debt in this way decreases your revolving balances, which will boost your credit utilization ratio. This, in turn, will bolster your credit score over time, assuming you don’t rack up new debt.

Pros:

  • A personal loan is a great way to consolidate debt and get your financial house in order before making the leap into homeownership.
  • Boosting your credit score over time will ultimately help you unlock the best terms and rates when you’re ready to apply for a mortgage.

Cons:

  • A personal loan isn’t ideal for a last-minute down payment, as it can negatively impact your debt-to-income ratio.
  • Fisher added that interest rates are typically higher on personal loans when compared with other financing options like HELOCs.
  • “Also, not everyone sits down and calculates the effect on monthly cash flow,” she said. “As we talk about layering financing, that’s something you have to do. If you use a personal loan for a down payment and still get approved for a home loan, can you comfortably carry the mortgage, taxes, insurance, plus the personal loan payment?”

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Get a loan from a community bank or credit union

When compared with a big lender, you may get better terms financing your down payment with a local community bank or credit union. This is exactly what Fisher recently did.

“I have a good relationship with my community bank, so I asked them if they’d extend an in-house loan to cover the down payment on my new house so that I could have a smooth transition while I listed my old house on the market,” she said.

“I incurred a $150 origination fee, and will pay a higher interest rate for a month or two, but it was well worth the convenience of not listing a house I lived in.”

Once Fisher sells her first home, she plans to pay off the down payment loan in full. In order for this to work, she made sure there were no prepayment penalties built into the terms.

Pros:

  • You may be able to get speedy financing at a reasonable interest rate, helping you bridge the gap between selling a home and buying a new one. Fisher compared this strategy to taking out a bridge loan — an often expensive form of short-term financing that uses your current home as collateral — but neither is risk-free.

Cons:

  • Any loan that has a monthly payment increases your debt-to-income ratio. Whether it’s an auto loan, personal loan or any other type of fixed monthly liability, it may impact your ability to get approved for a mortgage, according to Burns.
  • If you do take this route, be sure to weigh the costs of any origination fees and confirm there are no prepayment penalties for paying down the balance early.

Explore down payment assistance programs

There are a number of assistance programs out there that make it a whole lot easier for low- and middle-income buyers to scrape together a down payment. Begin the search at the state level with this handy tool from the U.S. Department of Housing and Urban Development.

You may qualify for a program that lets you make a reduced down payment or offers a low, fixed-rate mortgage. Similarly, the National Homebuyers Fund is a nonprofit that offers grants and other forms of support to ease the financial burden of saving for a down payment.

Assistance programs aside, looking beyond conventional home loans is another way you may be able to reduce your down payment size. Certain credit score requirements apply, but you could put as little as 3.5% down with an FHA loan, while VA and USDA loans boast no down payment for eligible borrowers.

Pros:

  • Down payment assistance programs may translate to a reduced, or even eliminated, deposit. In other words, it pays to do your research here.
  • Conventional loans aren’t the only way to get a mortgage. FHA, VA and USDA loans are viable alternatives for creditworthy applicants who don’t have 20% to put down.

Cons:

  • Making a smaller down payment with, say, an FHA loan, typically means having to pay monthly private mortgage insurance premiums until you reach the 20% equity mark.
  • On a similar note, a leaner down payment means you’ll have to borrow more from your lender — with interest.

Final thoughts

There’s more than one viable way to borrow money for a home down payment. If you’re selling one house and moving into another, you can leverage the equity you have in your current property with a home equity line of credit. You can also unlock funds with an in-house loan from a community bank or credit union if you don’t get hit on the back-end with prepayment penalties.

A personal loan, while not ideal for the down payment itself, is an excellent tool for consolidating debt and cleaning up your finances ahead of homeownership. Borrowing from friends, family or your nest egg are other ways to firm up your down payment. With the latter, just be sure you’re disciplined about paying yourself back and you’re all right with missing out on future returns. (It’s all about trade-offs.)

Before making any final decisions, first explore if you qualify for any assistance programs that either reduce or eliminate the down payment altogether.

 

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