Many people believe that before buying a home they need to have 20% of the purchase price in cash to use as a down payment. This can make home ownership seem overwhelming, as even buying a small property at a cost of $ 80,000 means having to have $ 16,000 on hand in cash, which is difficult for many households to save.
But the notion that homebuyers need to cut 20% is a common misconception. There are lenders out there who can help you get a mortgage if you haven’t saved so much for the down payment. Depending on your situation, it may even be possible to take out a mortgage without putting your own money on the line.
Just because you can potentially buy a house or apartment without losing 20% doesn’t mean you should necessarily do it. Let’s take a look at the pros and cons and see if it still makes sense to take a 20% down payment when buying a home.
It may seem like everyone who buys a home is cutting at least 20% of the purchase price, but statistics show that it’s not that simple. According to a recent report by Opendoor, 35% of baby boomers are far more likely to drop 26% or more in their next home, compared to just 11% of Millennials and 14% of Gen X, who both said they did it less down .
In fact, not even the majority of youngest buyers are losing 20%. According to the National Association of Realtors’ most recent Realtors Confidence Index, 52% of all non-cash buyers cut less than 20% of their home purchases last October, and a whopping 74% of first-time buyers saw less than 20% drop in payment.
“A down payment of less than 20% leads to higher interest rates and higher monthly payments. However, if you can buy a home sooner, you can start building equity in your home sooner, ”he says Nadia Aziz, GM, Home Loans at Opendoor.
Aziz says many lenders have products that customers can use to pay only 3% less. The U.S. Department of Agriculture (USDA) and Veterans Affairs (VA) even offer loans with no down payment options, but they are not available to everyone.
But of course there are downsides if it is reduced by less than 20%. You start out with less equity – that part of your home that you fully own rather than the bank having an interest in – and a larger mortgage. That means your monthly payments will be higher. Lowering less than 20% can have other ripple effects as well.
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To understand how your down payment affects the types of credit you are offered when buying a home, let’s start with how lenders rate a borrower’s risk. One of the factors that lenders consider is the loan-to-value (LTV) ratio. This is the amount you borrow compared to the amount your home is worth.
So if your mortgage is $ 80,000 and your home is worth $ 100,000, your LTV is 80%. The lower your LTV, the less risky the mortgage is for your lender and the more likely you are to get cheap loan terms.
Since a larger down payment, resulting in a lower LTV ratio, can help you qualify for lower interest rates, Aziz says it might be worth raising enough cash to make a larger down payment, even if it means having family members have to help.
“The down payment can be made from the borrower’s own savings and assets, or in some cases, lenders accept the down payment from a gift from a family member,” she adds, although a gift would need to be accompanied by documentation from the family member showing their relationship with the borrower and describes the purpose of the gift.
A gift from a family member can be a way to meet the 20% deposit limit.
In most cases, with a down payment of less than 20% on a traditional loan, you’re hooked on private mortgage insurance (PMI) as well. This is essentially an additional monthly fee on top of your mortgage payment that covers insurance costs in the event you default on your loan. According to LendingTree, the PMI is typically between 0.15% and 1.95%, but it can reach 2.5% or more.
“From the lender’s point of view, your down payment of less than 20% makes lending to you riskier, and the monthly PMI payments compensate the lender for taking that higher risk,” explains Aziz.
PMI is designed to protect the lender in the event you default on your mortgage, which means you personally don’t get any benefit from having to pay it. So if you save more than 20%, you can avoid paying PMI and lower your monthly mortgage costs with no penalties.
For a traditional loan, Aziz says you can request that your monthly PMI payments cease once your LTV rate drops enough. “The PMI should automatically decrease when the mortgage lending value reaches 78%. For an FHA loan, you have to pay the PMI – the FHA calls it the Mortgage Insurance Premium, or MIP – for the duration of the loan, ”she adds.
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Obviously, the biggest benefit of not paying a 20% down payment is that you don’t have to raise that much cash to buy a home. But what are the benefits of 20%?
- Smaller mortgage loan. A larger down payment results in a smaller mortgage balance that will pay off over time. “When market values go down, a larger down payment can help preserve equity,” says Aziz. A drop of 20% or more can also make a difference when it comes to refinancing or selling your home later.
- Pay less interest over time. According to Aziz, setting a lower mortgage rate and reducing your mortgage balance will lower the total interest you pay over the life of your loan. To see your savings, use a mortgage calculator to evaluate how much money a 20% down payment will save you over time.
- Lower monthly payments. Lowering 20% results in lower mortgage payments as you start with a smaller overall mortgage. This also saves you the extra cost of PMI.
- Higher purchasing power. A higher down payment means you can afford to buy a more expensive home. For example, Aziz says if you schedule a $ 1,000 monthly mortgage payment and can get 3% interest on a 30 year mortgage, with a 5% down payment you could afford to buy a $ 171,000 home , including about $ 685 per month for principal and interest, about $ 90 for PMI, and the rest for taxes and other expenses. With a 20% down payment, a $ 213,000 home would fit into your budget for the same $ 1,000 monthly payment since you wouldn’t have to pay a PMI (although you would have higher property taxes on a more expensive property).
- Larger loan options and terms. Tony Grech, a leading mortgage originator at Luxury Mortgage in Southfield, Michigan, says the higher your down payment, the more flexibility you have with loan amounts and loan programs. “Most loans that are above the compliance limit (jumbo loans) require at least 20%,” he explains. “And most Adjustable Rate Mortgage (ARM) programs don’t offer lower than fixed rates until you’ve got at least 20% less.”
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Every situation is different and a 20% deposit, while ideal, is not required.
A 20% deposit is a significant amount of money for most people. According to Opendoors report, 82% of Gen Xers and 93% of Millennials say they need to save for a down payment. For some people, wagering less and accepting a higher interest rate and monthly payment may make more sense when that means building equity in a home rather than paying rent elsewhere.
However, lowering 20% or more is an important goal for those looking to spend less on their mortgage overall. “It can make the home more affordable by helping you save money over time with lower interest rates and monthly payments,” says Aziz.
While a 20% down payment isn’t a set requirement when buying a home, it is a good idea if you can pull it off. But don’t assume that you are locked out of the home buying market just because you don’t have a lot of money. Instead, take a look at your options and see if a down payment of less than 20% makes sense for you.
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