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Borrowing Money for a Down Payment: How and When to Do It

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If you’ve built equity in your current home and you’re thinking of buying a new one, you may consider a home equity line of credit (HELOC) or home equity loan for your down payment. Or you might have a friend or relative willing to let you borrow money.

Before you decide on borrowing money for your down payment, it’s important to weigh the pros and cons of each option.

Take out a HELOC or home equity loan for a down payment

One option to find the cash for a new home is to get a home equity line of credit (HELOC) or a home equity loan (HEL) against your current home. The idea is to pay off the loan or line of credit when you sell the property.

A HELOC is a revolving line of credit that works like a credit card. Using a HELOC for a down payment allows you to:

  • Pay interest only on the amount you draw.
  • Use as much (or as little) of the credit line as you need during the draw period, which usually lasts 10 years.
  • Pay the balance to zero and charge it again during the draw period.
  • Make principal and interest payments on the remaining balance for up to 20 years when the draw period ends and the repayment period starts.

If you opt for a home equity loan for a down payment, you’ll receive money in a lump sum, and make fixed monthly installment payments based on the rate and term you choose. Standard HEL terms are five to 15 years.

Pros and cons of tapping home equity for a down payment

Pros  Cons 
  You’ll get a lower rate than other types of loans.   You could lose your home to foreclosure if you default.
  You can borrow up to 85% of your current home’s value.   You may have to pay closing costs of 2% to 5% of the loan amount.
  You may avoid private mortgage insurance (PMI) on your new home with a 20% down payment.   You’ll have to qualify with two mortgage payments.
  You’ll leave more cash reserves in the bank.   You may have a variable interest rate on a HELOC and, in turn, higher monthly payments.
  You may be able to make a low, interest-only payment on a HELOC.   You may have a prepayment penalty when you pay off your HELOC.

 

Mortgage pro tip: Use a HELOC or home equity loan as a piggyback down payment

If you can come up with a 10% down payment, taking out a HEL or HELOC on the home you’re buying to come up with another 10% of the down payment will help you avoid PMI on a conventional mortgage. This is called a piggyback loan. It comes with an added bonus: You may be able to deduct the HEL or HELOC interest on your taxes because you’re using the money to purchase the home that secures the piggyback loan.

Get a loan from a friend or family member

Tapping a friend or family member for your down payment is another option. However, private mortgage loans from family have to be secured by an asset, like real estate, artwork or an automobile, to be acceptable to your new mortgage company. You’ll have to qualify with the new payment, so be sure to discuss the terms with your loan officer when you’re getting your mortgage preapproval.

Document the following items if you go down this borrowing path:

  • The terms of the loan including the loan amount, repayment term and monthly payment.
  • A statement from the friend or family member saying that they have no interest in the home you’re buying.
  • Evidence you’ve received the funds from them.
  • Proof of the asset the loan is secured by.

If you have a family member willing to gift you money for your down payment, you can use those funds as long as they’re willing to sign a gift letter confirming no repayment is expected. You’ll also need to provide paperwork showing the money going from your relative’s account into yours.

Pros and cons of asking a friend or relative for a down payment loan

Pros  Cons 
  You won’t have to apply for approval.   Your relative or friend becomes your lender.
  You’ll leave your home equity alone.   Your relationship may suffer if you fail to repay the loan.
  You can choose flexible repayment terms.   You’ll have to qualify for a mortgage with the new payment.

Tap your retirement savings

Retirement savings are designed to see you through your golden years — not bankroll big-ticket purchases. But if the path to those years includes homeownership, you may want to use those savings to purchase a home.

If you have a 401(k) account, you can take out a 401(k) loan for your down payment. A 401(k) loan allows you to take a distribution you can repay over time. You can borrow up to 50% of your account balance or $50,000, whichever is less, according to the IRS. Consult a financial planner or an accountant before taking a loan or a distribution.

Pros and cons of taking out a 401(k) loan for a down payment

Pros  Cons 
  You’re borrowing against your own money.   You’ll have to pay the entire balance back if you lose your job.
  You’ll have easier approval terms.   You might pay additional penalties if you default.
  You won’t pay any tax penalties if you’re a first-time homebuyer.   You’re reducing future returns on your retirement funds.

Get a bridge loan

Your local bank or credit union may offer short-term bridge loans so you can take equity out of a home you’re selling to buy a new home. Bridge loans come in handy if you’re in a tight housing market where sellers aren’t willing to accept an offer that’s dependent on selling your home first.

There are two different types of bridge loans: a first-mortgage bridge loan and a second-mortgage bridge loan.

  • First-mortgage bridge loan. You’ll take out one large loan — typically up to 80% of your current home’s value. After your current loan balance is paid off, the difference can be used as a down payment on your new home.
  • Second-mortgage bridge loan. With this option, you borrow up to 80% of the difference between your current home loan as a second mortgage (similar to a HEL or HELOC). This may be a good option if you have a low interest rate on your current mortgage, especially since bridge loan rates tend to be much higher than traditional mortgage rates.

Pros and cons of getting a bridge loan for a down payment

Pros  Cons 
  You can tap equity while your home is listed for sale.   You may end up with two to three simultaneous mortgage payments.
  You don’t have to wait for your current home to sell to buy a new one.   You’ll pay higher rates and closing costs.
  You’ll avoid moving twice since you’re tapping equity to buy your new home before the old one sells.   You’ll have to qualify with all of the mortgage payments, and could lose two homes if you default on the loans.

Explore down payment assistance programs

If you aren’t able to borrow money for a down payment, find out if you qualify for a down payment assistance (DPA) program. 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 grants, second mortgage programs or even first-mortgage DPA loans through a local bank. However, some programs may have income limits and additional guidelines for how long you have to remain in the home in order to qualify.

Pros and cons of using a down payment assistance program

Pros  Cons 
  You may not have to borrow money for a down payment at all.   You may not be eligible if you make too much or don’t buy in a targeted neighborhood.
  You’ll only have one monthly payment.   You might have to pay PMI with less than 20% down.
  You may not have to pay the money back.   You may have to pay the assistance back if you don’t stay in your home long enough.

 

 

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