The Low Down on Down Payments

20 Percent Down RegulationAs with most investments, you will never be absolutely certain that you are buying the right house with the perfect mortgage.  This is doubly true if you’re a first time home buyer.  An unfortunate mix of misinformation, dated information, and flat out myths related to mortgage and financing options can put you in a position where you are closing doors that were once wide open.  What is the biggest myth out there?  The one that leads to more missed opportunities and costly mistakes than any other?  Simple – that you always need a 20% down payment in order to purchase a home at competitive mortgage rates.

Here’s the reality.  There was once a time when a 20% down payment was not only the norm, it was effectively required by the majority of lenders.  That time has long since passed and loan programs offered today empower qualified buyers to bid on their dream homes with competitively priced mortgages that require little to no down payment.

In the market for a new house?  Plan on using a mortgage?  You’ll need to fully appreciate mortgage terms, programs, and down payment requirements before you get to your first real open house.  Appreciating the ins and outs of how low and no money down mortgages works not only leaves more money in your wallet, but also gives you a faster way to get the home you really want.

Understanding Down Payments

For years you’ve heard that a sizeable down payment on a house is critically important, but you’ve likely never heard why that down payment matters to borrowers or lenders.  A down payment is simply the money you bring to the buying table when purchasing a house.  It is the sum you pay out of your own checking or savings account, rather than out of a debt you’ve taken from a mortgage lender.  The larger the down payment, the smaller the mortgage and lower your payment will be.  Large down payments have other major advantages, they reduce PMI, a type of insurance you pay for that protects the lender from your non-payment of the mortgage, and they save you a fortune in interest over the term of your loan.

Just as homes are different, each mortgage program and lender has different down payment requirements.  When it comes to down payment requirements, they “can be anything the lender will approve you at” says Dana Graham, a Realtor with Berkshire Hathaway California Properties says.  For instance, not all lenders favor down payments that consume all of your free cash.  Some prefer that you keep a substantial reserve to ensure that you can keep making mortgage payments even when emergencies hit.  It turns out that there is something to be said for keeping that rainy day fund alive, stocked, and well.

Certified Financial Planner Eric Meermann reported that many of his clients were unaware that lenders relaxed the traditional 20% down payment requirement.  “That’s good news for people who want to take advantage today of low interest rates,” said Meermann. It’s also good news for the 60% of first time home buyers who are buying homes with down payments of 6% or less.

The bulk of conventional mortgage lenders require buyers putting down less than 20% of a home’s value to pay private mortgage insurance (“PMI”).  While PMI can sometimes be acceptable, as paying it for a short period of time may put you into a home in a hot market at a time when waiting to build a down payment would result in you being priced out, borrowers can often use a number of strategies to avoid PMI while still getting preferable financing.  Whether this means purchasing borrower funded single premium mortgage insurance, a one-payment PMI equivalent, or using second mortgages to fund your down payment and avoid PMI, is something you should decide with your mortgage advisor.

Lower Down Payment, Bigger Returns

Size-able down payments are not always wise.  They may help you reduce or avoid PMI and can certainly result in less interest charged over the term of the loan, but finance experts warn that the strategy of making large down payments is more economically risky than you might otherwise think.

What advantages come with lower down payments?  Smaller down payments let you make use of financial leverage.  In situations with small down payments, buyers experience large returns on investment “if the home appreciates, and the greater the percentage loss if the home loses value,” says Casey Fleming, author of The Loan Guide: How to Get The Best Possible Mortgage.  Smaller down payments also mean less of your money is tied up in the property, so risk of catastrophic loss is greatly reduced.

Smaller down payments also allow buyers to retain size-able liquid cash reserves that can be accessed in case of emergency.  While money tied up in your home can be accessed through the use of a line of credit, home equity is generally slower to access than funds sitting comfortably in a bank account or investment brokerage.  Making matters worse, initial down payments are “expensive and hard, if not impossible, to pull out of the home,” adds Flemming.  Why is accessing down payment funding so challenging?  Because while lenders may be willing to extend credit to buyers with no-money-down, few will offer second mortgages on properties with little or no equity pas the initial down payment.

Finally, while home ownership is generally a sound investment, there is always a risk that your property’s value could decline over time.  Larger down payments made today may turn out to be terrible investments yielding negative returns on dollars down the road.

The Fundamentals On No Down or Low Down Payment Loans

It’s never been a better time to be a low down or no down buyer of a property.  Successful mortgage programs currently offered allow buyers to make rock bottom down payments and still qualify for funding.  Some of these programs include:

  • USDA loan – 0% down payment required
  • Conventional loan (with PMI) – minimum 3% down payment
  • Jumbo loan – minimum 10% down payment
  • VA loan – 0% down payment required
  • FHA loan – minimum 3.5% down payment
  • Fannie Mae HomeReady loan– minimum 3% down payment
  • Freddie Mac Home Possible loan – minimum 3% down payment

If you’re in a position where you want to understand all of your options, don’t stop with these programs.  “There are many national, state, and county grant programs that allow consumers to utilize grants for down payment assistance should a consumer not have the 3.5% or 3% down needed for the FHA, Fannie Mae, or Freddie Mac loans,” says David J. Hosterman, a manager with Castle Cook Mortgage in Colorado.  While many of these grant programs are targeted to first time buyers, many accept more experienced buyers.  There is no harm in applying for programs to see whether assistance is available.

Show Them the Money!

Who is the best applicant for a low or no money down mortgage?  According to Flemming, it’s the buyer with steady income and:

  • a limited probability of unemployment
  • wages that are not solely derived from commissions
  • strong credit ratings – responsible users of credit who carry small (or preferably no) revolving credit balances are safer customers to loan money to because they are less likely to run up unsustainable credit card bills.
  • large capital or cash reserves. Buyers holding onto healthy emergency funds after closing can better weather the financial storm when it inevitably comes

If you’ve decided to use a down payment to purchase your home or you need to meet a certain minimum down payment, make a few sacrifices now and get creative when it comes to getting financing.  Start living on a written budget, “forgo that $200 dinner or that cruise on the Mediterranean if you really want to have your own place,” says Graham.  Remember, your house wasn’t built in a day and it’s unlikely that your emergency fund will be, either!

When it comes to alternative or creative funding, consider asking friends or family members for financial gifts.  Lenders generally demand proof that money from family members or friends really was a gift, but this proof is easily provided in the form of a gift letter.  Whatever you do, do not agree to private loans from family members or friends without first speaking to your mortgage broker.  These loans can complicate or ruin any chance you have at getting competitive financing.

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