Why Do You Need a Down Payment, Anyway?

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One of the most intimidating aspects of buying your own home – particularly your first home – is the down payment. In most cases, lenders look for a cash down payment of 20% of the home’s value, which can add up to a lot of money.

Let’s look at some real numbers to see how difficult the problem really is. The median home price in America right now is close to $250,000, while the average American household income is around $60,000. A 20% down payment on a $250,000 home is $50,000, and that doesn’t even include extra expenses like closing costs and moving costs. Having a full 20% down payment on the average American home while still being able to afford to move will cost the average American family a year’s worth of salary. That’s an incredibly difficult pill to swallow.

So, is a down payment on a home really necessary? The short answer is no, but not having one is very costly.

Why do lenders want a down payment?

For lenders, if you bring a down payment, they’re actually lending you less money, so why would they want you to have one? Well, there are a few reasons.

First of all, remember that lenders want to lend when the risk is low. They want to lend money to people in situations where they’re sure that the loan will be paid back on time, with payments being made on time. That’s why lenders want to know so much about you when they lend you money – your credit report, your credit score, your employment history and any other debts you have. Your lender will assess how much risk it’s taking when lending you money. It is not a good outcome for a mortgage lender if you’re frequently late with payments or if it has to foreclose your home. When you’re late or when you default, it means the lender takes that as a loss — and you do too, when filing bankruptcy or defaulting on your mortgage. Lenders want to lend money to low-risk borrowers who will just make their payments on time.

A down payment indicates that you’re financially stable. You have this pool of cash and you didn’t spend it on other things. That is a clear indication of financial stability to the lender, creating a clear positive picture along with your good credit and employment history. Even if you were simply given a down payment by a relative, that indicates you have a social network around you that can help out financially in a pinch, which is another good sign.

Without a down payment, mortgages require PMI

Many lenders recognize the challenge that having a full down payment gives to first time home buyers and thus they will typically still lend home buyers who have good credit, even offering good mortgage rates.

What’s the catch? Private mortgage insurance (PMI) is the catch.

Private mortgage insurance is a way for lenders to reduce the risk to themselves when otherwise good borrowers come to them wanting to buy a home without sufficient down payments. It’s an insurance policy that the lender sets up on your behalf that will pay the lender if you’re unable to keep making your payments.

Often, when you go to a bank for a conventional loan without a full 20% down payment, the lender will still offer you a good rate, but it’ll require you to take out such a policy. Typically, PMI costs about 1% of the value of the home each year if you have good credit, so if you buy a $250,000 home, your PMI policy will cost $2,500 a year or about $200 a month. This is often wrapped directly into your monthly mortgage payment, as your lender will set up the policy for you.

So, if you borrow $250,000 at 3% on a 30-year mortgage, your monthly payment would be about $1,040, but the PMI would add another $200 per month on top of that.

How do you get rid of private mortgage insurance? Typically, once you’ve paid off 20% of the value of the home, it falls off automatically. You can also contact the lender to have the PMI removed early if you can demonstrate that the value of your home has increased significantly such that the mortgage is now less than 80% of the value of the home. This creates added incentive to make extra monthly payments, as eliminating PMI quickly will be a big money saver.

[Related: PMI: What Is Private Mortgage Insurance?]

What about FHA loans?

Some people may have made credit mistakes in their recent past but still want to buy a home at a reasonable interest rate. In those situations, they can apply for a FHA loan.

An FHA loan is a home mortgage that is guaranteed by the federal government, meaning that lenders are more likely to lend money to people with so-so credit because of that federal government guarantee. FHA loans do require a down payment in most cases, but that down payment is as little as 3.5% of the value of the home.

The catch here is that FHA loans come with a mortgage insurance premium (MIP). MIP is similar to PMI in that it’s an additional cost on your mortgage payment, except that it doesn’t fall off automatically. Typically, it either lasts for 11 years or for the full length of the mortgage, depending on the specifics of your loan. The only way to get rid of it is to either pay off your mortgage or to refinance it later. The actual amount of MIP varies from loan to loan, but ranges anywhere from 0.4% of the home’s value to a bit over 1% of the home’s value, or somewhere between $80 to $200 a month on our mortgage example.

[Read: What Is an FHA Loan?]

Should I buy a house now or wait?

The ability to save up for a down payment is a great litmus test for whether or not you can afford a home. If you struggle to save money from month to month in a rental situation, owning a home right now is probably not a good financial choice for you. This isn’t a question of whether you’re able to put aside money each month for a down payment, but whether you actually do so. Are you making the choice each month to save for that home, or are you living paycheck to paycheck?

My recommendation is to run the numbers to see how much the cost of owning your desired home will actually be. By this, I don’t just mean the monthly mortgage payment plus PMI. You should also include things like property taxes, homeowners association fees, all utilities, homeowners insurance and monthly maintenance and improvement (you’ll probably spend 1% of the home’s value a year on maintenance). Add all of that together and add an extra 10% on top of it for things you’re not yet considering. Can you afford that much each month? If you think you can, put your money where your mouth is and live by it. Spend at least a year putting that total amount into savings each month, then paying for rent and utilities out of that savings account, leaving the rest in place as savings for a down payment. If you can’t pull this off, then you aren’t financially prepared to buy.

What if you are financially prepared? You have a good job and are able to afford that expense each month, but you simply haven’t had the time to save up enough for a 20% down payment. What then? In that situation, it is not a bad idea to buy in a period where mortgage rates are extremely low, as you can lock in those low rates on your mortgage and pay down that mortgage until PMI falls off or you can refinance to get rid of MIP.

Too long, didn’t read?

In today’s financial marketplace, where home mortgage rates are incredibly low, the most important factor in your decision to buy should be whether you can afford the monthly cost of a 15-year mortgage with PMI attached to it. If you believe you can handle that, live it for a year or so and put aside the difference between your calculated amount and your actual rent. That exercise alone will give you the start of a great down payment and also demonstrate that you do have the self-control and financial means to make this work.

Once you’re sure that you’re financially ready for the expense (and mortgage rates remain historically low), start talking to lenders and see what options are available for you.

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