Borrowing your down payment

It may be the biggest hurdle homebuyers face: how do I come up with the money for a down payment?

While saving up for your down payment is the ideal approach (well, having a rich uncle give you the money may be the ideal approach, but not an option for most), there are situations where the timing or financial circumstances don't allow for such a gradual approach. In that case, borrowing for your down payment is an option.

There are several reasons to consider borrowing for a down payment, and fortunately there are also several ways of doing it. Just be advised that there are also some risks and costs you need to be aware of before opting for this approach.

Reasons for Borrowing a Down Payment

First, here are some reasons why you might borrow for your down payment:

  1. Get into the housing market sooner. When real estate prices are rising quickly, would-be homebuyers fear getting priced out of the market before they can get a down payment saved. Another situation is when rents are fairly high compared to the cost of owning a home, making it difficult to accumulate a down payment while you are still renting. In either case, borrowing your down payment can get you into a house sooner.
  2. Capture an attractive mortgage rate. Low mortgage rates can save you thousands of dollars over the life of a mortgage, but those rates can be volatile – here today and gone tomorrow. Borrowing for a down payment can help you lock in your rate while they are still low.
  3. Lower your primary mortgage rate. A bigger down payment on a home can allow you to qualify for a lower rate on your primary loan. It will probably mean paying a higher rate on the down payment loan, but given that this will likely be much smaller than your primary mortgage and can be repaid sooner, the interest cost over time should be much less.
  4. Avoid or lower PMI. Mortgages with low or no down payments often require private mortgage insurance, or PMI. Borrowing for your down payment can help you avoid having this extra cost tacked onto your primary mortgage.
  5. Keep a liquid reserve. First-time home owners who put every resource into their purchase often find themselves strapped for the cash needed for the unexpected expenses that come with owning property. Borrowing for your down payment rather than draining your savings will allow you to keep a little money in reserve for unforeseen needs.

Ways to Borrow for Your Down Payment

If some or all of the above reasons for borrowing for your down payment apply to you, here are some of the methods you can use to come up with that loan.

  1. Personal loan. A bank might be willing to make you a personal loan to use toward your down payment. However, you will probably need excellent credit to qualify for an unsecured loan.
  2. 401k or IRA assets. If you have retirement savings in a 401k or IRA, you may be able to borrow against it. You may be able to borrow up to the lesser of $50,000 or 50 percent of your 401k plan balance, and first-time homebuyers may qualify for an exemption of up to $10,000 from early IRA withdrawal penalties. Be advised, though, that not all plans permit borrowing, and whether you borrow from your 401k or take a distribution from your IRA, tapping into these resources even temporarily is likely to slow down your accumulation of retirement savings. Also, be advised that some 401k plans require the immediate repayment of loans if you leave your current employer.
  3. Borrowing from a friend. If a bank won't give you a loan, you might have a friend or relative who is willing to do so. This arrangement may be formal or informal, but you might want to document the repayment and interest terms in order to qualify for the mortgage interest deduction.
  4. Peer-to-peer lending. A new twist on borrowing from a friend is to use peer-to-peer lending to find people who are willing to lend you money as an investment.
  5. Borrowing against home equity. If you already own a home, you might use the equity in that home as a source of your down payment via a home equity or cash-out refinancing loan. This might be relevant if you are buying a second home, or plan on moving to a new home but do not want to rush the sale of your current home in order to pay for your next one.
  6. Local programs.There are state and local programs in some areas which allow would-be homebuyers to qualify for loans or even grants to help with their down payments.

What to Be Careful of When Borrowing for Your Down Payment

There are drawbacks to borrowing for your down payment, and here are some things you should watch out for:

  1. Managing your overall payments. Borrowing rather than saving for your down payment will mean you owe more money every month, and give you an extra debt obligation to monitor. It might also complicate your tax and retirement saving situations.
  2. Higher interest rates on unsecured loans. If you are able to get a non-mortgage loan to use for your down payment, chances are it will be significantly more expensive than your mortgage.
  3. No cushion against financial setbacks. Borrowing the down payment means you start off as a home owner with no equity in the property. This means if you are forced to sell, you may still owe more than the proceeds from the sale of the property.
  4. Not all mortgages allow for borrowed down payments. Be sure to find out if the mortgage you are applying for even allows you to borrow for the down payment. Some lenders prefer the security of knowing the borrower is not so leveraged, and has put some money into the property up front.

Borrowing for a down payment can be a viable way of financing a home, but it will both complicate your financial situation and increase your monthly payments. Just make sure you both understand and can afford the obligations you take on before using this approach.

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