If that’s your dream, you are likely saving up, dollar by hard-earned dollar, until you have that magic number: 20% of your dream home’s total value. That’s what all the experts say, right?
For the average American home, 20% amounts to a pretty big number. Throw in closing costs and you’ve got a small fortune to raise – and years to go until you reach your goal.
It’s great that you’re putting money away toward what will likely be the largest purchase of your life, but there’s one huge mistake in your calculations: You don’t need to put down 20%.
Yes, you read right. The 20% myth is an unfortunate leftover from the era after the housing crisis, when out of necessity, access to credit tightened up. Thankfully, times have changed, and since FHA loans were introduced more than 80 years ago, mortgages have not required a 20% down payment.
While it’s true that a higher down payment means you’ll have a smaller monthly mortgage payment, there are lots of reasons why this isn’t always the best road to owning a home.
Let’s explore loan options that don’t require 20% down and take a deeper look at the pros and cons of making a smaller down payment.
If you’d like to go the route of government-backed loans, these are your options:
1. FHA mortgage: This loan is aimed at helping first-time home buyers and requires as little as 3.5% down. If that number is still too high, the down payment can be sourced from a financial gift or via a Down Payment Assistance program.
2. VA mortgage: VA mortgages are the most forgiving, but they are strictly for current and former military members. They require zero down, don’t require mortgage insurance and they allow for all closing costs to come from a seller concession or gift funds.
3. USDA home loan: These loans, backed by the United States Department of Agriculture, also require zero down, but eligibility is location-based. Qualifying homes need not be situated on farmlands, but they must be in sparsely populated areas. USDA loans are available in all 50 states and are offered by most lenders.
If you’d rather take out a conventional loan, though, you can choose from the following loan types:
1. 3% down mortgage: Many lenders will now grant mortgages with borrowers putting as little as 3% down. Some lenders, like Freddie Mac, even offer reduced mortgage insurance on these loans, with no income limits and no first-time buyer requirement.
2. 5% down mortgage: Lots of lenders allow you to put down just 5% of a home’s value. However, most insist that the home be the buyer’s primary residence and that the buyer has a FICO score of 680 or higher.
3. 10% down mortgage: Most lenders will allow you to take out a conventional loan with 10% down, even with a less-than-ideal credit score.
Bear in mind that each of these loans requires income eligibility. Additionally, putting less than 20% down usually means paying for PMI, or private mortgage insurance. However, if you view your home as an asset, paying your PMI is like paying toward an investment. In fact, according to TheMortgageReports.com, some homeowners have spent $8,100 in PMI over the course of a decade, and their home’s value has increased by $43,000. That’s a huge return on investment!
Why make a smaller payment?
If you’re thinking of waiting and saving until you have 20% to put down on a home, consider this: A RealtyTrac study found that, on average, it would take a homebuyer nearly 13 years to save for a 20% down payment. In all that time, you could be building your equity – and home prices may rise. Rates likely will as well.
Other benefits to putting down less than 20% include the following:
- Conserve cash: You’ll have more money available to invest and save.
- Pay off debt: Many lenders recommend using available cash to pay down credit card debt before purchasing a home. Credit card debt usually has a higher interest rate than mortgage debt – and it won’t net you a tax deduction.
- Improve your credit score: Once you’ve paid off debt, expect to see your score spike. You’ll land a better mortgage rate this way, especially if your score tops 730.
- Remodel: Few homes are in perfect condition as offered. You’ll likely want to make some changes to your new home before you move in. Having some cash on hand will allow you to do that.
- Build an emergency fund: As a homeowner, having a well-stocked emergency fund is crucial. From here on, you’ll be the one paying to fix any plumbing issues or leaky roofs.
Cons of smaller down payments
In all fairness, there are some drawbacks of making a smaller down payment.
- Mortgage insurance: A PMI payment is an extra monthly expense piled on top of your mortgage and property tax. As mentioned above, though, PMI can be a good investment.
- Potentially higher mortgage rates: If you’re taking out a conventional loan and making a smaller down payment, you can expect to have a higher mortgage rate. However, if you’re taking out a government-backed loan, you’re guaranteed a lower mortgage rate despite a less-than-robust down payment.
- Less equity: You’ll have less equity in your home with a smaller down payment. Of course, unless you’re planning to sell in the next few years, this shouldn’t have any tangible effect on your homeownership.
Of course this doesn’t mean you should buy a home no matter how much – or how little – you’ve got in your savings account. Before making this decision, be sure you can really afford to own a home. Ideally, your total monthly housing costs should amount to less than 28% of your monthly gross income.