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Should You Go Beyond the 20 Percent Down Payment?

For many people, saving up enough money for a down payment on a house can feel like an impossible task. Indeed, a recent survey conducted by Trulia found that the down payment was the biggest hurdle for nearly 60 percent of potential homebuyers.

But what if you’re on the other end of the spectrum? What if you have more than enough money for the traditional 20 down? Does it ever make sense to make a larger down payment on a house?

In this post we’ll break down the pros and cons of a larger down payment to help you decide what’s right for you.

The significance of 20 percent

The 20% down payment was originally required to protect banks from suffering a big financial loss in the event that they needed to foreclose.

A foreclosed home represented dollars that the bank couldn’t lend to the community. Selling that home at a 20 percent discount generally allowed them to move it quickly, so the 20 percent down payment was established to protect the bank from the potential loss they would face in foreclosure.

The industry has changed, though, over time. Fannie Mae and Freddie Mac routinely buy mortgages from lenders, reducing much of the risk that banks used to assume. And while putting 20 percent down used to be one of the only ways you could buy a house, there are now a number of programs that let you get in the game with a much smaller down payment.

Still, 20 percent has largely remained the standard, and there are some good reasons to make a 20 percent down payment if you can afford to do so:

  • Smaller monthly payment. A bigger down payment means a smaller loan, which leads to a smaller monthly payment.
  • No PMI. Many lenders require you to pay for mortgage insurance if you put less than 20 percent down, which increases both the upfront and monthly cost of the mortgage.
  • Lower interest rate. You might get a lower rate than a borrower with a smaller down payment. According to Doug Crouse, a mortgage banker with Farmers State Bank in Kansas City, Mo., putting 20 percent down will generally lower your interest rate by 0.25 percent compared with buyers making smaller down payments. Just keep in mind your rate is impacted by your credit score as well.
  • Reduced closing costs. Certain closing costs, such as the lender origination fee, are tied to the amount of the loan. You can reduce these costs by putting more money down.
  • Qualifying with lower credit score. Crouse says that a bigger down payment can make it easier for people with a lower credit score to get a mortgage, since it reduces some of the lender’s risk.
  • Flexibility. If for some reason you need to sell your house quickly — say there’s a sudden job loss or a transfer — having equity in your home gives you more flexibility to potentially sell at a discount without having to bring additional cash to closing.
  • Quicker path to debt freedom. You can pay off your mortgage much sooner if you put 20 down. Smaller loan. Lower interest rate. No PMI. It all stacks up to your benefit.

Still, there are some downsides to making a 20 percent down payment, too:

  • Sacrificing other savings. A lot of people think that they have to put 20 percent down and empty their bank accounts in order to do so. This leaves them without an emergency fund or other savings, which can put them in a precarious situation.
  • Opportunity cost. With mortgage interest rates at all-time lows, and with the potential to deduct that interest on your tax return (for now — proposed GOP tax reform plans might eliminate the mortgage interest tax deduction), you may be better off taking out a bigger loan and investing that down payment elsewhere.
  • A big hill to climb. Crouse notes that in some markets it’s difficult to save money fast enough to keep up with rising home prices. In that situation, making so large a down payment simply may not be a reasonable goal.
  • You have other options. There are a number of loan programs available now that allow you to buy a house with less money down. It’s may be worth exploring those other options to understand whether you may be better off going another route.

Why you should consider putting down more than 20 percent

With the 20 percent standard, when might it make sense to make an even larger down payment on a house?

One occasion has to do with interest rates.  Sure, the best interest rates are often offered to people who have a FICO score of at least 760. But you can also potentially get a lower rate with a larger down payment, which Crouse says he’s seen many times in his career. Specifically, he says he’s seen the best rates go to homebuyers with at least a 760 FICO and a down payment of 30 percent.

A larger down payment could make sense for people who have significant savings but more modest income. By using that savings to put more money down, you can reduce your monthly payment and make it easier on your monthly budget.

Beyond that, many of the benefits of a larger down payment are simply extensions of the reasons why 20 percent down seems sensible.

  • Lower closing costs
  • Less interest paid over the life of the loan
  • More equity in your home gives you more flexibility to sell or borrow on short notice
  • You can potentially buy a bigger home if you are willing to put make a larger down payment
  • You can potentially get to debt-free even sooner

In other words, the main benefits of a larger down payment are short-term savings in the form of smaller monthly payments, and long-term savings in the form of reduced interest costs over the life of the loan.

Disadvantages of a larger down payment

While making a larger down payment on a house can make sense, and while it can certainly save you money, here again there are also downsides to ponder.

The biggest consideration is how the down payment will affect your other financial needs.

Once you’ve put money into your home, the only way to get to your money is to refinance, sell your home, or take a line of credit. Life has emergencies, and it’s very important that before making a large down payment you at least have a sufficient emergency fund and a budget set aside for home repairs.

Crouse mentions opportunity cost as another potential downside to making a larger down payment, especially if you can secure a low interest rate and you’re able to itemize deductions, which reduces the cost of your interest payments.

In that case, Crouse argues that you might be able to earn a higher return elsewhere, either by investing the money or by paying off higher-interest debt, such as student loans.

The bottom line is that your mortgage should never be viewed in a vacuum. It’s important to evaluate any decision within the context of your overall financial situation.

Low down-payment mortgage options

Despite the benefits of putting 20 percent or more down on your home, you might not be able to afford that kind of down payment right now. And even if you can, there may be good reasons to put less down and apply your cash elsewhere.

With that in mind, here are a few programs that can either help you afford a larger down payment or allow you to put less than 20 percent down.

Low-down-payment mortgage options
Type of loan Down payment requirement Mortgage insurance and other fees
FHA 3.5 – 10% MI required for life of loan
HomeReady 3.0% MI required until LTV reaches 80%
Conventional 3.0 – 20% PMI required until LTV reaches 80%
SoFi 10% None

Down payment assistance programs

The first thing any prospective borrower should do is look for down payment assistance programs in the area in which he or she is buying.

There are 600-plus down payment assistance programs and homebuyers often aren’t even aware that these are available to them. In some cases you can get up to a $25,000 grant that’s forgivable if you stay in the house for at least five years.

The National Council of State Housing Agencies website can help that helps you find down payment assistance programs in your area.

If you qualify, these programs can help you make a larger down payment than you would have been able to afford on your own.

FHA loans

FHA loans are backed by the Federal Housing Administration, meaning that the federal government guarantees that they will pay the bank for the loan if you stop making payments.

In return for that guarantee, banks are willing to provide mortgages with lower down payments and looser credit requirements. People with a credit score of 580 or higher can secure an FHA loan with as little as 3.5 percent down, and people with a credit score of 500-579 can put as little as 10 percent down.

The downside is the mortgage insurance. You are typically required to pay both a 1.75 percent upfront premium and a monthly premium, and your mortgage insurance lasts for the entire life of the loan.

Still, if your credit is less than perfect and you don’t have 20 percent to put down, an FHA loan can be a lifesaver.

Fannie Mae HomeReady

The Fannie Mae HomeReady program is specifically designed to help people with relatively low incomes.

In general, your income must be at or below the median income for your area, which you can look up here. From there, you can qualify with a credit score of 620 and above, or by going through a special underwriting process if you don’t have enough of a credit history to have a score.

If eligible, you can get a mortgage with as little as 3 percent down. And while mortgage insurance is required, it can be financed into the loan, And unlike FHA loans it is removed once your Loan-to-Value ratio reaches 80 percent.

Low-down-payment conventional mortgages

It is possible to get a conventional mortgage — without going through any special program — with a down payment as low as 3 percent. Your eligibility will vary by lender and will depend on your credit history, income, and assets.

Private mortgage insurance will be required if your down payment is less than 20 percent, but you can remove it once your Loan-to-Value ratio reaches 80 percent.

SoFi

SoFi offers mortgages of up to $3 million with as little as 10% down and no PMI and no loan origination fees.

The offer fixed and adjustable rate mortgages over 15-30 year terms, but you typically need excellent credit in order to secure a loan.

No-money-down mortgage options

If you truly can’t afford to put any money down, there are a few options, anyway.

No-down-payment mortgage options
Type of loan Down payment requirement Mortgage insurance and other fees
VA 0% 1.25% – 2.4% one-time funding fee
USDA 0% 2% upfront premium
Doctors As little as 0%; 5% to 10% common No MI

VA loan

VA loans are backed by the Department of Veterans Affairs and allow eligible veterans to purchase homes with nothing down as long as they have “satisfactory credit”. According to Crouse, you can qualify for a prime interest rate even with a credit score in the mid-600s.

Another benefit is there’s no mortgage insurance, though there is a one-time funding fee of 1.25-2.4% of the loan value.

“The VA loan is a phenomenal product,” says Crouse. “As far as options for 100 percent financing, this one in particular really stands out. It’s something I would like to see more veterans take advantage of.”

USDA loan

USDA home loans are available to people with low to moderate incomes who live in eligible rural areas. Most lenders underwriting USDA loans require a minimum credit score between 620 and 640 with no significant delinquencies, foreclosures or bankruptcies in the past several years.

If you meet those requirements, you can get a mortgage with 0 percent down and a 2 percent upfront mortgage insurance premium that can be folded into the loan, meaning that you can pay the premium over time if you’d like.

Doctor loan

People in the medical profession can get a “physician’s loan” with as little as zero down (although down payments of 5 percent to 10 percent appear to be more common), no mortgage insurance requirement, and rates that are competitive with conventional loans.

This can be helpful for medical professionals who are just starting out and aren’t earning much now but expect their incomes to increase significantly in the future. But it can also be helpful for people already several years into the profession who would simply rather put their money elsewhere.

Says Crouse: “A lot of doctors would rather have 100 percent financing and use the money to pay off student loans instead. It represents a better return on investment.”

Should you make a larger down payment?

As with most financial issues, the decision to make a larger down payment comes down to tradeoffs.

On the one hand, a larger down payment reduces the overall cost of your mortgage and can remove certain fees altogether. On the other hand, a smaller down payment might leave more money for other financial goals, and there are a number of programs that can help you make a smaller down payment without adding too much extra cost onto your shoulders.

In the end, trust your gut.

It’s important to be aware of your options, but you still have to stick with your gut If you’re losing sleep at night because of the size of the down payment you made or didn’t make, that’s not worth it. Understand your options and make a choice you’re comfortable with.

 

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