You want to buy a home, but don’t have the illustrious 20% to put down on it. Does this mean you can’t buy a home? Today it doesn’t mean that. You can buy a home with as little as 3.5% down on an FHA loan or no money down on a USDA or VA loan
You might wonder, is there a problem if you don’t put a lot down on the home? Here we discuss the pros and cons of making minimal down payments so you can see how they may affect you.
The Upside of a Low Down Payment
Let’s assume you only put 5% down on a $200,000 home. Here we will look at the positives of doing so.
- You get to buy a home – Let’s face it, if all lenders required at least 20% down on a home, there would not be as many homeowners today. The fact that you can put less than that down in many cases helps you get into a home.
- You may have a larger savings account – There’s a big difference in putting 5% down on a home than 20% down. On our $200,000 home, it means a difference of $35,000. That’s not chunk change. Even though you might not have $40,000 lying around to decide whether or not you should put it down on your home, you may have some money left in your savings account. This is crucial for new homeowners, as you never know what expenses may come your way.
- Gives you a little diversification – Your home is a place to live, but it’s also an investment. If you put all of your money into the home, it leaves nothing to invest elsewhere. What happens if we experience another housing crisis? Suddenly you’ve lost all of your investment and could end up homeless too. That doesn’t sound like the ideal situation.
The Downside of a Low Down Payment
Of course, there is always a downside, no matter how positive something may seem. Putting just 5% down could put you in a difficult situation if you aren’t careful. Here are the most common pitfalls of this practice.
- You’ll have limited equity – Putting little money down on a home means, you have very little equity. It’s easy to end up upside down as the housing crisis showed us. Also, if you plan on moving in the next few years, you may end up paying money out of pocket to sell your home if it did not appreciate enough to give you wiggle room in the sales price.
- You’ll pay mortgage insurance – Conventional loans require borrowers to pay Private Mortgage Insurance if they put less than 20% down on a home. Some government-backed loans, such as FHA and USDA charge annual mortgage insurance premiums for the life of the loan. Either way, it’s extra money you must pay each month in exchange for the small down payment.
- You’ll get a higher interest rate – Lenders often determine your interest rate based on the risk you pose. The more ‘skin in the game’ you have, the less risk you pose. Putting down 3-5% on the home is not a significant investment. Lenders may increase your interest rate as a result of you borrowing such a large portion of the home’s value.
- You’ll pay more each month – A higher interest rate means a higher monthly payment. But, putting down less money also means you borrow more money. Put those two factors together and you have a much higher monthly payment than if you put down 20% on the home.
- You may lose a bidding war – Putting little money down on a home reflects negatively on sellers too. They may worry that your financing will fall through and choose a different bidder that will make a larger down payment. If you are in a bidding war, you want to make yourself look as favorable as possible. Generally, this means conventional financing with a 20% down payment. But, even government-backed financing with a larger down payment may help you win the war.
If making a small down payment is all that you can afford, there’s nothing wrong with doing it. Just make sure you understand the ramifications of doing so. We recommend taking the smallest mortgage amount that you can without sacrificing living space in your home.
Remember that lenders will base your interest rate on the amount of money you borrow. If you borrow 95% of the home’s value, there’s not much for the bank to fall back on if you default. They will make up for this risk with a higher interest rate. Taking the time to save a little more money for the down payment can save you money each month by borrowing less and netting you a lower interest rate.
If you can’t afford the large down payment, you have options. There are plenty of programs available to you. Make sure you compare all of the terms and determine your future plans. Is this your forever home or will you move in a few years? This will help you make your decision as well.