Saving for a down payment is one of the biggest challenges to becoming a homeowner. Conventional wisdom says you should save 20 percent of the home’s purchase price to offer as a down payment, but where did this number come from? Do you really need to put that amount down or is less OK? What about more? Does that have any added benefit?
Questions about down payments abound — and we’ve got answers. Read on to learn more about down payments, why they’re required, and how much is enough to get you into your new home.
What Is a Down Payment?
If you’ve talked to other homeowners or to real estate professionals, you’ve probably heard the phrase “down payment” or discussed how much a friend “put down” on their new home. The down payment is just that, an up-front payment toward the total cost of the home made by you to the seller, although it usually feels like you’re making that payment to the mortgage lender. The amount is generally expressed as a percentage of the purchase price of the home, thus the phrases “20 percent down” or “10 percent down.”
Most lenders require some sort of down payment in order to provide you with a home loan as it offsets some of their risk. If you buy a $100,000 home, for example, and put 3 percent down, you’ll pay the seller $3,000 and take out a mortgage for $97,000. But if you put 20 percent down, you’ll pay $20,000 and only need an $80,000 mortgage.
Do You Need to Put 20 Percent Down?
In a word, no. However, putting 20 percent down will help you avoid paying extra on your mortgage. Home loans secured with less than 20 percent down must include private mortgage insurance or PMI. PMI is loan protection for the mortgage lender. If you default on your mortgage while carrying PMI, the lender will be repaid a portion of your loan amount. Even though PMI benefits the lender, the homeowner pays for it as part of their monthly mortgage payment.
According to Investopedia, PMI typically costs between 0.5 percent and 1 percent of the loan amount annually. So, for our $100,000 home, you would pay $83.33 per month (nearly $1,000 a year) based on a 1 percent PMI fee.
So, although 20 percent is not required as a down payment, it does provide some cost savings long-term by eliminating PMI and reducing your overall loan amount. Some traditional lenders offer mortgages for just 5 percent or 10 percent down, while government-backed loans like FHA loans require as little as 3.5 percent down. VA loans are even better: Qualified servicemen and women, veterans or surviving spouses can get home loans with no down payment required.
With so many loan options out there, it’s always a good idea to shop around for home loans until you find one that meets your needs.
Down Payment Amount Can Influence Your Mortgage Loan Terms
In general, the more money you can put toward a home up front, the more attractive you’ll be as a mortgage customer. A higher down payment equates to less risk for the lender, which can lead to many benefits for you, including no PMI, but also:
- Qualifying you for lower interest rates
- Improving your loan-to-value ratio, which impacts how much you can borrow
- Qualifying you for better mortgage terms and offers
- Offsetting a poor credit score
A smaller down payment won’t necessarily disqualify you for a mortgage loan, but being able to make a larger down payment puts you in a better position to get a loan and at terms more favorable for you. Anything you can do that reduces your risk in the eyes of your lender increases your changes of securing a mortgage.
How Much Down Payment Should You Provide?
Before you start worrying about a down payment, the very first thing you should do is talk to a mortgage lender to see if you even qualify for a loan. Lenders will examine your credit score, debt amounts, and income levels to determine how much home you can afford. They’ll want to see no more than 28 percent to 30 percent of your monthly income dedicated to housing and a reliable income stream that will allow you to repay any loan you take out.
If you don’t qualify for a loan, they’ll tell you why and give you actions to take that can help you qualify. At this point, you are better off working to improve your ability to secure a home loan than saving for a down payment.
If they do pre-qualify you for a loan, ask how different down payment amounts could affect your mortgage choices. You’ll be surprised to see how much rates and terms can change with higher down payments.
Use this down payment calculator from Smart Asset to see how different down payment amounts and loan terms can affect your monthly payment.
Don’’t Confuse the Down Payment With Other Costs
One last thing to keep in mind: Don’t confuse the down payment with other home purchasing costs like earnest money and closing costs.
- Earnest money, also known as good faith money, is paid to the seller to indicate your commitment to buying a home. It’s a deposit that is applied to the full down payment amount; the amount is dictated by local home-buying customs, but typically is about 1 to 2 percent of the home’s purchase price. Sometimes, earnest money can be retained by the seller if the buyer backs out of the deal, but it’s primarily used to show sellers that you are a serious buyer who is committed to making the purchase.
- Closing costs are over and above both the down payment and earnest money. These out-of-pocket expenses are paid when you close on your home and can range from 2 to 5 percent of the purchase price. They cover things like title searches, attorney’s fees, notary fees, appraisals, home inspections, credit reports, property tax escrow payments, and homeowners insurance. Closing costs vary from state to state and are based on the specifics of your home purchase.
Liyya Hassanali is a Project Manager and Content Strategist for Kinship Design Marketing, a boutique agency that provides marketing strategies and content for architects, interior designers, and landscape designers. She is a 15+ year veteran of the marketing and advertising industry, working closely with her clients to provide written content that meets their marketing goals and gets results.
Liyya is passionate about home design and décor and is a confessed HGTV and Pinterest addict. When not providing content writing services for her clients, she can be found browsing home décor sites or spending time with her family.