If there’s one thing that holds many people back from buying a home, it’s the lack of a down payment. It’s a common myth to think that you need to save at least 20% to put down on a home. While in a perfect world it would be nice, it’s not necessary.
Keep reading to learn just how much money you should save for your down payment.
Do you Want Conventional Financing?
The first thing you need to ask yourself is if you plan to try to get conventional financing. This is the typical financing that people with ‘good credit’ can get. This is the loan that carries the 20% down payment requirement myth. While it’s true that a 20% down payment is nice, it isn’t absolutely necessary.
The 20% down payment will help you avoid paying Private Mortgage Insurance. PMI is required when you make a down payment of less than 20%. In reality, the minimum down payment required on a conventional loan is 5%. That’s a big difference from the 20% myth.
If you do put less than 20% down on the home, you will pay PMI until you owe less than 80% of the home’s value on your mortgage. You’ll know when this will occur when you receive your amortization table. This table breaks down when you will owe less than 80% of the home’s current value. The good news is that you may owe less than 80% of the home’s value even earlier.
If your home appreciates at a fast rate, you may owe less than 80% of its value quicker. This is especially true if you make extra payments towards your loan’s principal to pay the balance down even faster. With most conventional loans, you are able to request elimination of the PMI once you owe less than that 80% mark.
If you don’t think you’ll have the credit to qualify for a conventional loan, your next best bet is government-backed financing. The most common options are the FHA, VA, and USDA loans. Each loan has a specific audience that it addresses:
- FHA loans – If you have a credit score of at least 580 and 3.5% to put down on the home, you may qualify for an FHA loan. You don’t have to be a first-time homebuyer to use this program.
- VA loans – If you are a veteran of the military with at least 181 days served during peacetime or 90 days served during wartime, you may be eligible for this program. You must also have an honorable discharge.
- USDA loans – If you buy a home in a rural area and make less than 115% of the average income for the area, the USDA loan is a good option.
The nice thing about government-backed loans is the low down payment requirements. In these cases, a 20% down payment is completely unnecessary. As we said above, FHA loans require a 3.5% down payment. Luckily, if you don’t have the funds yourself, you can use gift funds from a relative or employer. VA loans don’t have a down payment requirement, which means you can borrow 100% of the purchase price of the home (if the appraisal supports the price), and USDA loans don’t require a down payment.
With government-backed loans it doesn’t help to make a larger down payment than the minimum requirement. Unlike conventional loans, you will pay mortgage insurance for the life of the loan. The only exception is the VA loan, which doesn’t require any mortgage insurance. The only fee that you pay is a funding fee at the start of the loan.
How Does a Down Payment Help?
Once you know the minimum required for your loan program, you can decide how to proceed. Of course, if you put more money down on the home than is required, you put yourself in a better financial position. You’ll have equity in the home and you’ll pay less interest over the life of the loan. The less money that you borrow, the less interest you will pay to own the home.
Before you make a down payment, though, consider your financial situation. Ask yourself:
- Do you have an emergency fund that could cover you should you lose your income or disaster strike?
- Are you free of consumer debt? This means that you don’t have any credit cards or personal loans outstanding.
- Do you have money set aside for retirement?
If you answered ‘yes’ to all of the above questions, then you are in a good position to put more money down on the home. On the other hand, if you have consumer debt or you don’t have an emergency fund, you shouldn’t risk your money to put it down on the home. You tie the funds up in an illiquid investment and you end up paying more in interest over the life of the debt with the credit cards outstanding.
Figuring out how much to save for a down payment is a personal decision. At the very least, you will need enough to satisfy the loan’s requirements. Other than that, it is up to you how much that you put down based on your financial situation. In the end, the larger the down payment that you can make on a home, the sooner you will own your home free and clear of a mortgage.