Buying a home is probably one of the biggest purchases you will ever make. Therefore, it is important to understand exactly what goes into buying a home.
If you don’t save enough money to buy a house completely upfront and in cash, you will need to get a mortgage to borrow enough money to buy a house.
If you get a mortgage, you will have to make what is called a down payment. A down payment is money that is paid upfront when you buy a house. The down payment is usually part of the total cost of the house, but the mortgage or mortgage loan is meant to cover the rest of the cost of the house.
What is the down payment?
A down payment is cash paid upfront for large purchases, such as a home. You use the loan to pay for the rest of the purchase price over time. The down payment is usually a percentage of the price. If you pay a 10 percent down payment on a $350,000 home, you get $35,000.
When you apply for a secured home loan, the down payment is your contribution to the purchase and represents your initial share of home ownership. Mortgage lenders provide the rest of the money to purchase the property.
Borrowers require a down payment on most secured loans. However, some types of federally backed loans may not require a down payment. (See below for more information on this)
How does the down payment work?
A down payment shows borrowers that you’re serious enough about owning a home to invest the money you save in real estate. Your investment helps you prove that you think the property is a reasonable purchase and that you intend to pay the required mortgage. A prudent person would not invest their savings in a property that they think is worth less than the asking price, or plan to abandon it if things get tough.
However, since borrowers invest more money in real estate than you do, they will order an appraisal to get an independent and professional opinion of the property’s value. You will also check your credit rating, income and debt to see if you can pay the loan.
How much do I have to pay for a down payment when I buy a home?
The amount you need to buy a home depends on the type of loan you get and the requirements of the mortgage lender. Your income, cash flow, credit rating and overall repayment ratio can affect your eligibility and loan terms.
Generally, an existing loan that is available or guaranteed through a debtor or one of the two government-sponsored companies, Fannie Mae or Freddie Mac, requires a down payment of at least 5%. However, since some traditional loan programs only allow for a 3% down payment, this may be an option for people who are first-time homebuyers and others with less cash on hand.
In other words, if you make a down payment of 20 percent on an existing loan, you can avoid paying for personal mortgage insurance, which is PMI, which can significantly increase your mortgage each month. According to the Urban Institute, PMI typically costs between 0.19% and 1.86% of the loan amount each year.
20% is not a magic number for any type of secured loan. Other loans accept much smaller amounts. FHA loans require as little as 3.5%, and VA and USDA loans require no down payment at all.
How to save for a down payment?
- Create a budget. If you don’t already have a budget, you can keep track of your monthly income and expenses. This will help you determine if you can afford to put more money into a down payment.
- Cut back on expenses. Once you determine your budget, find areas where you can cut back on your expenses, such as canceling unused subscriptions or cooking at home from the comfort of your own home. Then you can put the money you save into your savings goals.
- Open a special savings account. With a down payment-only account, it’s easier to see how much you’ve saved and how much more you’ll need. Consider using an account that may earn higher interest than a regular savings account, such as a high-interest savings account, a money market account or a transferable certificate of deposit (CD).
- Repay your debt. High-interest debt, such as credit card debt, can make it difficult to make a down payment. If you can wait for a down payment, it may be a good idea to invest extra cash to pay off the debt. This allows you to save money on interest and have more financial flexibility. If you pay off your debt, your overall repayment ratio (DTI) will also be lower, allowing you to get a mortgage loan.
- Suspend your other savings goals. While not ideal, you can temporarily suspend your other financial goals to focus on saving for a down payment. For example, you can withhold a 401(k) donation and use it as a down payment. Don’t touch other savings accounts, such as emergency funds or Individual Retirement Allowances (IRAs), to avoid financial hardship later.
There are advantages to paying more down payments.
Being able to save on your down payment is a good indication that you’re ready to make a financial commitment to buy a home. Here are some obvious benefits of waiting for more down payments:
Lower mortgage rates. The less money you borrow as a percentage of the value of your home, the less risk the loan poses to the mortgage lender. As a result, the more down payments, the lower the interest rate, the more correlated it tends to be.
Equity increases. The higher the percentage of homes you own, the more equity you have. This can be especially helpful when trying to finance large remodeling projects or other purchases, since cash refinances, home equity loans or home equity lines of credit (HELOCs) allow you to borrow money relatively cheaply compared to the value of your home.
Lower monthly payments. Because you are likely to borrow less money and have lower interest rates, you can expect fewer monthly payments and can provide more cash flow for other financial goals and lifestyles.
Finishing costs are low. The fees you pay to the borrower at closing are usually calculated as a percentage of the total loan amount, so the less you get the loan, the less you owe at closing.