When buying a home the vast majority of Americans will make a down payment to cover a
portion of the purchase price. That initial payment plays a crucial role in loan approval and will
affect the cost of the loan for its’ duration. For this reason, it is important to understand how
down payments work and determine the payment amount that is best for you and your goals.
So what exactly is a down payment? The down payment is the up-front portion of the home’s
purchase price that you pay yourself, out-of-pocket and most often comes from savings. This
can be done by a check, credit card, or electronic payment.
Down payments, however, are not always part of a loan. Sometimes you’ll find zero-down loan
options, like from the USDA, VA, or Navy Federal Credit Union, which opens up a lot of
possibilities for a home purchase, but also equates to a higher overall loan amount, and as a
result, higher payments.
Traditionally, twenty percent down has been the standard for home loans to avoid paying private
mortgage insurance (PMI), but Is 20% really the best option for you? Everyone’s circumstance
is different, so you’ll need to take into account your own personal situation. If your income is
low, but you have savings for a down payment, putting 20% down would be the right decision to
avoid paying PMI. If you have good household income but very little in the way of savings, it
may be best to see if you can qualify for a low or zero down payment loan, while planning to
cancel your mortgage insurance once you have 20% equity in the home.
Let's examine some of the primary benefits of making a large down payment (20% or more):
1. A smaller loan balance and …
2. The most obvious benefit is you will decrease your monthly payments. Nothing feels
better than a smaller, more manageable monthly payments!
3. In some cases, you may qualify for a lower interest rate and better terms. You may also
obtain favorable terms by showing a consistent work history, asking your bank for a
better rate, or paying for points.
4. Reduced mortgage insurance premiums. Mortgage insurance covers the risk of
borrowers not repaying their loans. The size of your down payment affects how much
mortgage insurance you have to pay, how long you have to pay it, and the size of your
premiums. Usually, if you pay less than 20% for a down payment, you’ll have to pay
PMI. PMI is insurance that protects the lender in the event a borrower defaults.
So, if in your case, bigger is better, the next question is where to get the money for your down
payment? The most obvious place is your cash savings. If you’re young and just starting out
and are intent on buying a home, focus your efforts into saving as much money as you can
quickly for your down payment. Forgo retirement savings for the time being and put everything
you have into a high-interest earning savings account, invested for the down payment.
If you’re older and already have money invested in a retirement plan, you still have options.
Another option is to take out a 401k loan for the purpose of a home purchase. You can withdraw
up to $50,000 or half the value of the account, whichever is less. This approach is less costly
than cashing out a retirement plan completely since you will not owe a penalty. This route isn’t
without issues, however. a 401k loan is considered regular debt by mortgage lenders, so it can
affect your credit score as well as your debt-to-income ratio, which could impact your approval
for a home loan. The loan must be paid back with interest and you only have a few years to pay
it back, so if the amount you withdraw is large, so too can your monthly payments.
If you have much in the way of assets, such as a second car, jewelry, etc., consider selling
those items. You’d be surprised how much value we have just laying around our homes or
sitting in storage. The internet makes it easy to sell everything from clothes to electronics.
Don’t wait too long to save money for your down payment, because the real estate market is
constantly changing, and this change might affect you in an adverse way.
The pros and cons of a large (or small) down payment encompass several factors, including
your local real estate market, and your own personal financial situation. Once you understand
whether a large or small down payment makes more sense for you, the next step is to figure out
how to come up with the money you need and how to structure getting a loan.