Coming up with a down payment is probably the biggest hurdle for first-time home buyers. The recommended down payment is a whopping 20 percent. On a $250,000 home, that’s $50,000, which is more than just a few months of skipping a morning latte.
In an ideal world, you would set aside a good chunk of change every month for a few years until you reach your down payment goal. But the reality is that if you’re in a rising housing market with low interest rates, waiting to save up could actually cost you money in the long run. The good news is, you don’t have to win the lottery or wait and watch housing prices grow more quickly than your savings. You have down payment options.
How much do you really need?
Traditionally, 20 percent is the gold standard for down payments, for a lot of really good reasons. You’ll find more lenders to choose from, lower interest rates and you won’t pay any form of the dreaded private mortgage insurance (PMI). But there are lower down payment loans that may make sense. If you are a U.S. veteran, you can even get a zero-down VA loan without any PMI.
Fannie Mae and Freddie Mac offer something called the Conventional 97 loan. You only need 3 percent down and you can use a cash gift from a family member to make the down payment. So for a $250,000 house, you’d need just $7,500 down, either from your own savings or a gift. The loan still requires private mortgage insurance, which benefits the lender but not you. You can ditch the PMI once you hit 20 percent equity, but that may require you to refinance.
If you qualify for an FHA loan, you can get in with just 3.5 percent down. An FHA loan doesn’t require the same excellent credit score that the Conventional 97 does and may come with a lower interest rate. But you’ll be paying the PMI for the life of the loan if you put down less than 10 percent, so crunch the numbers before deciding.
Most traditional mortgages start with a minimum down payment of 5 percent, with PMI required. For a $250,000 house that’s $12,500 upfront cash, not including any closing costs. You can play around with down payments and see how they affect things like the interest rates you’re offered here.
Where’s the money going to come from? You have three options: Beg, borrow or save.
OK, hopefully you won’t have to actually beg. But ask nicely? Maybe call your parents more often? The truth is that gifts from parents are the down payment plan for a lot of us. But in this case, getting them to write the check isn’t your only hurdle. You’re going to have to account for the gift to your lender. Don’t hope they won’t notice the $10,000 deposit into your savings account last month. They will.
And they will want to see a letter from your parents or whatever family member gave it to you, confirming that it’s a gift and not a loan that you’ll need to repay along with your mortgage. (And it does need to be a family member. Lenders look askance at anything unusual in this arena. Be prepared to explain any large gifts that fall outside of what they might expect.)
There are also limits on gift funds. Right now the annual gifting limit is $14,000 to an individual, per person, before taxes rear their heads. If your parents each make a gift to you, that’s $28,000. If you are married or buying the house with someone else, your generous parents can gift that much to each of you, bringing the total to $56,000 a year. But don’t go over that amount for the entire year. The gift tax, ironically, isn’t imposed on the person getting the gift but on the giver.
Down payment assistance programs are another option for down payment help. Sadly, many home shoppers aren’t even aware that these programs exist. But the good news is that sites like the Down Payment Resource Center let you search for programs near you.
If it seems counterintuitive to go into debt to make a down payment on more debt, you’re right. But buying a home is different than other types of debt because it’s an investment that will hopefully appreciate. Still, consider this option carefully before committing to it. And wherever you borrow the funds from, you need a solid plan for repaying it. Like any investment, there is no guarantee your home value will rise.
For a lot of folks, the good old Bank of Mom and Dad is there, willing to help with excellent interest rates and flexible payment schedules. But mortgage lenders will almost never lend you money if your down payment comes in the form of a loan like this. They, understandably, want you to have skin in the game. That’s not to say people don’t violate this rule. Mom and Dad sign a “gift letter” acknowledging that they don’t expect repayment. That satisfies the bank.
But you still have a non-legally binding understanding. How will you repay them? Will it be in small monthly payments or are you going to give them their money back in five years when you sell the house or refinance it? Or are you planning on producing a grandchild who will so enthrall your parents they will forget about the money? (Caution: This is an expensive repayment plan.) What happens if Mom loses her job or needs to retire early and they need the money back sooner than expected? You can’t amortize guilt, but you might want to in this situation. Think long and hard before taking this route.
Another option, albeit one you should be equally cautious with, is to borrow from yourself by taking out a loan from your retirement funds. If you borrow from your 401(k) to make a down payment, you’ll be repaying yourself over time. But be careful. If you lose your job or even just switch to a new employer, you’ll have to repay the loan at once or be subject to hefty early-withdrawal fees. You’ll also be repaying the loan with after-tax dollars. If you have an IRA, you can take up to $10,000 out without penalty to purchase a primary residence if you are a first-time home buyer. Most experts will advise you, however, that the risk is simply not worth the potential cost.
OK, not as much fun as a gift and certainly not with the instant gratification of a loan. But saving for a down payment is still a time-honored, financially solid plan. If you have credit card debt, focus on paying that off first. Chances are whatever you are paying in interest on those is going to be higher than any home appreciation. Plus, getting rid of that debt will greatly improve your debt-to-income ratio and help you get a better mortgage.
If you’ve got non-retirement investments, maybe a forgotten savings bond or some stock you bought and held on to, consider whether you want to cash them out and reinvest the funds in a house. Downsize your rental and stash the savings each month.
If you are stretched so thin you really can’t put anything of substance toward a down payment savings account each month, you may not be ready for homeownership. Once you own your home, if a pipe bursts or your furnace goes out, you no longer get to just call the landlord. So while you do have that option, stash away cash each month. If you get a bonus or other windfall, save it. Saving for a down payment is excellent practice for saving money to take care of unexpected home repairs.
When considering your down payment and loan options, it’s also a good idea to talk to a local lender early in your home search. They can asses your financial situation and help you understand what type of loans you’d be eligible for.