How important is a 20% down payment?

When it comes to putting a down payment on a home, the 20% rule may be less important than your personal budget. Ultimately, your ongoing monthly mortgage payments are going to have a much bigger impact on your finances than your initial down payment, so as you think about how much to save and put down, it’s important to keep the different moving pieces in mind.

Where did 20% come from?

When you take out a mortgage, you acquire ownership of your house slowly, and the share you own outright is known as equity. Many lenders want you to have meaningful equity in your home from day one. 

If you don’t put at least 20% down, you generally need to pay private mortgage insurance (PMI), which is essentially an insurance policy that you’ll continue to pay your mortgage. PMI can increase your monthly costs early on in your mortgage. 

Legally, you can file a request to cancel PMI once you build up 20% equity in your home, based on the original purchase price. However, with a 3% down payment, you may be paying PMI for nearly a decade before you qualify for cancelation if refinancing is not a viable option. 

Think about the big picture

Ideally, you want your expenses as a homeowner to line up with whatever expenses you’re currently paying for housing. If you’re in a $2,500-a-month rental unit, sticking to a $2,500 monthly mortgage payment can help you stay on track financially.

Increasing your down payment can be one of the best ways to lower your monthly payments going forward, and unlike mortgage rates, it’s a factor you have some control over.

A larger down payment can also help protect you from fluctuations in the housing market. If you put a small percentage down and your home falls in value, you may end up underwater on your mortgage—owing more than the house is worth. 

Still, the housing market can be unpredictable, so while it’s helpful to consider the evolution of the home prices in any area you’re considering, your personal finances should be a much bigger consideration.

Buying a house without a big down payment

It isn’t always possible to put 20% down, but not having that amount up front can impact not just the amount but the overall terms of your mortgage. This is especially true when the economy shows signs of weakness and/or interest rates are high or increasing.

In uncertain economic environments, banks may be less willing to lend money, and therefore, may use a stricter review process before extending credit.

A lower down payment may also translate to a higher mortgage rate over the course of the loan, which may lead to you paying more in overall interest. 

Coming up with a down payment

When it comes to saving for a down payment, coming up with a specific plan can help. Think about the neighborhood you want to buy in and the type of house you are aiming to purchase. This can give you a rough sense of home prices and mortgage payments, which can help create a goal for your down payment. From there, you can build a savings plan to help you get to that amount.

Once you start budgeting to set the money aside, we recommend clients keep that money in an income-centric, principal-protected account.

It’s also important to realize that like many financial goals, saving for a home can be a moving target. Not only do home prices fluctuate, but mortgage rates, property taxes, and even your individual needs may change over time. Plus, the down payment is just one factor; lenders also look at your credit score, the other assets you own, and more. 

Beyond saving: Other down payment options

There are a few so-called short cuts that may be able to help you buy a home without saving up for a large down payment. However, many of these approaches should be treated with caution.

For instance, first-time homebuyers could borrow money from an employer-sponsored retirement account, like a 401(k). While that may sound appealing, you have to pay back any money you borrow, which creates another monthly expense on top of your new mortgage payments. It’s likely your lender will ask to review the terms of any withdrawals to ensure you’re not overextending yourself repaying the down payment alongside your primary home loan.

Gifts from friends or family are another popular option for funding down payments. However, there are a few restrictions to keep in mind. First, if someone gives you funds in excess of $15,000, they need to document the gift with the IRS and pay a gift tax. If your family structures the gift as a loan instead of a gift, you’ll need to create a formal arrangement that includes repayment terms and interest rates.

Keep in mind: A gift or loan from family may be a red flag for lenders. Financial institutions monitor your statements in the months leading up to your home purchase; if lenders see a sudden influx of cash, they may assume you’re relying on outside funds and are less financially stable, which could impact your mortgage rate and terms. 

If you make less than a certain amount, you may qualify for an FHA loan, which requires a smaller down payment. If you’re a veteran, VA loans also tend to offer favorable terms for down payments.

Finally, some banks offer programs meant to help first-time homeowners, which may include a path toward purchasing with a smaller down payment. The terms of this type of program may vary by lender and your personal circumstances. 

While the number of moving pieces can feel intimidating at first, Reason Financial is here to help you prioritize and evaluate your choices. If you’re thinking of buying a house, we can work together to figure out a timeline and savings strategy that makes sense for your situation.

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