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Housing prices continue to escalate, and that has created a down payment problem for many potential homebuyers. Experts will tell you there are certain advantages to putting down at least 20%, but if you’re a first-time homebuyer, saving up that amount of money can be daunting and take years.
It can also cost you a lot more money over the long run, especially when you have other options that can mean less initial out-of-pocket expenses to get you into a home quicker.
The Advantage of Putting Down at Least 20%
If your finances allow, when you put down at least 20% on a home purchase, you’ll avoid the additional cost of paying for mortgage insurance.
Mortgage insurance is billed as part of your monthly mortgage statement and typically runs up to 1% of your loan amount annually.
You can also cancel mortgage insurance on conventional loans once your loan balance falls to 78% of the original home value through regular amortization or request to have it canceled after the balance reaches 80% of the home’s current value when supported by an assessment. The exception is FHA mortgage insurance, which is more difficult to get rid of, but you can jettison it by refinancing into a new loan once you reach 20% equity.
With 20% down, you’ll also qualify for the lowest mortgage rates, and combined, you’ll pay much less monthly in mortgage payments.
A 20% down payment also provides instant equity in your home purchase. It can provide a cushion if you encounter personal financial issues or the housing market cools off and prices start to go lower.
You can sell or refinance if needed and do not have to put up any additional money unless there’s a big decline.
You are not required to put 20% down on a mortgage unless you have bad credit or are taking out a large loan. Several options will allow you to buy a home with as little as 0-3% down, even if your credit is less than perfect.
What About Smaller Down Payments?
The big advantage of a smaller down payment is that it allows you to buy a home now instead of waiting years to save up a 20% stake. If you’re renting, the longer you wait, the more money you’re flushing down the drain instead of building equity in an asset you own.
If you’re ready to buy when mortgage loan rates are low, there’s no guarantee those rates will remain low if you wait, possibly costing you thousands of additional dollars in higher interest rates. Waiting makes more sense when rates are high, and you’ll need to do an opportunity cost analysis to decide whether all the factors work in your favor.
» MORE: See today’s refinance rates
Small Down Payment Options
If you’re looking for a mortgage with a small down payment, these are some options to consider.
FHA Home Loans
This is the classic low-down-payment mortgage. FHA mortgages require only 3.5% down and are available through most lenders. They have less stringent credit requirements than most other types of mortgages and offer better interest rates for borrowers with flawed credit.
The downside is that you may have to pay more in fees than on other types of mortgages, and you have to carry mortgage insurance for the life of the loan if you put less than 10% down. You can always refinance out of your FHA mortgage once you reach 20% equity, but there’s also the risk that mortgage rates will be higher when you do.
Still, they’re a good choice for borrowers just beginning to establish their credit or have some blemishes on their credit history.
Fannie Mae/Freddie Mac Loans
Often referred to as “conventional” or “conforming” mortgages, these are the most common types of home mortgages in the United States. Fannie Mae and Freddie Mac do not make loans but provide backing for loans that meet certain standards.
Many lenders offer these mortgages for as little as 3% down, though 5-10% minimums are more common. Credit standards are higher than on FHA loans, but these mortgages typically offer better terms for borrowers with good credit.
Veterans and others with military affiliations can purchase their first home with no money down in most cases and often on subsequent properties. Interest rates and other terms are attractive, making VA loans the preferred choice for most eligible veterans looking to buy a home.
USDA Rural Development Loans
This federal program offers mortgages with no money down to eligible borrowers. Eligibility is income-based; homes purchased must be modestly priced, and borrowers must currently lack adequate housing.
Homes purchased under this program technically must be in rural areas, but the definition includes many small towns and suburbs.
State and Local Housing Agencies
Though they aren’t actual mortgage programs, many state and local housing agencies offer down payment assistance to help borrowers with a down payment. These may be loans, grants, or other assistance that varies by location.
Good Neighbor Next Door Program
The U.S. Dept. of Housing and Urban Development (HUD) has a program that allows members of some public service professions, including police, firefighters, EMTs, and K-12 teachers, to obtain mortgages with only $100 down in targeted neighborhoods.
Using a Second Mortgage as Part of a Down Payment
Another way to avoid mortgage insurance is to take out a second “piggyback” mortgage at the time of purchase to cover part of the down payment.
In these cases, you take out a primary mortgage for 80% of the purchase price with no mortgage insurance and then take out a second mortgage to cover the difference between your down payment and the primary loan. For example, if you make a 15% down payment, you would also take out a piggyback loan for 5% of the purchase price to cover the difference.
They are typically limited to covering smaller differences between the cash you have and the 20% mark you’d need to avoid paying for mortgage insurance. Interest rates on second mortgages are higher than on primary loans, so you’ll have to run the numbers to see if they’re a better option for you than paying for mortgage insurance.
Drawbacks of a Small Down Payment
You can buy a house sooner than you might otherwise with a 20% down payment, but there are some downsides to consider if you go that route.
You’ll pay for mortgage insurance on any home purchase loan where you put less than 20% down unless it’s a VA loan because the VA insures the loan for you.
Mortgage insurance generally costs between .5-1% annually and may even run a bit higher depending on your situation, especially if you take out an FHA loan.
Smaller down payments mean higher mortgage payments because you borrow more of the purchase price.
For example, putting 20% down on a $250,000 home purchase means you’re borrowing $200,000, whereas putting 5% down on the same home means borrowing $237,500.
On a 30-year fixed-rate mortgage at 7% interest, the first would give you a monthly mortgage payment of $1,664, whereas the second would require a monthly payment of $2,067, plus roughly another $100-$250 a month for mortgage insurance, depending on your credit score and the type of loan you get.
Smaller down payments are also riskier for your lender. Lenders like big down payments because it gives them a cushion in case the property goes into foreclosure and they have to sell it for less than what you paid.
From a buyer’s point of view, if you default on your loan and lose it to foreclosure, would you rather do so and lose the 3.5% down payment from your FHA loan or lose the 20% or more down payment that you have been scraping together for years?
Even if you default on a mortgage with a small down payment, your lender is still protected with mortgage insurance. It covers the difference between your down payment and 20% down, so the lender still gets 20 percent of the home value to cover any foreclosure losses in the event of default.