Whether you have actively searched for a home or you’re simply considering the prospect of homeownership, you’ve likely come across the subject of a down payment. In fact, you’ve probably heard, by at least some people, that you absolutely need a 20% down payment; if you don’t have it, don’t bother shopping.
Despite popular myth, it is entirely possible, and may be financially feasible, to purchase a home with less than 20% down. If you can afford it, 20% is usually the best choice, but most people simply can’t. Even if they have the money on hand, a 20% down payment can wipe out savings, leaving you vulnerable to financial difficulties in the future.
We’d like to show you why securing a loan with less than 20% down may be the right choice in certain situations. But first, let’s look at how this 20%-down myth got started…
20% Down: The Holy Grail of Mortgage Numbers
Mortgage lenders (and lenders of all varieties for that matter) are in the business of reducing risk. They use statistics and probabilities to measure the chances of a person defaulting on a loan, and use these stats as a basis for lending decisions.
Statistically speaking, if you have a large down payment, you are less likely to default on the loan. Also, when you put 20% down on the loan, lenders are giving you less money, which means the financial impact of a possible default is lessened.
If you have 20% down (or more) lenders are more likely to approve your loan application. They are also more likely to give you better terms, including lower interest rates. With lower interest rates and less money borrowed, this could mean savings worth tens of thousands of dollars over the life of the loan.
If you don’t put 20% down on your home, you’ll have to pay mortgage insurance until you make enough payments to reach 20%. Mortgage insurance, also known as private mortgage insurance and “PMI,” is essentially an insurance protection for the lending institution against your default on the loan, which is statistically higher than if you don’t have 20% down. The only caveat is that the lender doesn’t pay the insurance; you do. PMI is not a huge addition to the cost of the loan, but it does add up. You’ll usually find rates are about .3 to 1.5% of the original loan amount, added to the monthly loan payments. Most people will pay about $1,000 to $2,000 per year on mortgage insurance, although this can go up or down depending on the size of your loan, your credit score, and other factors.
This makes it all sound like paying 20% down should be the ultimate goal, but as you’ll see, there are some situations when purchasing a home with less than 20% down is a wise decision…
When to Purchase a Home Without 20% Down
Free Your Cash for Other Purchases
One of the top advantages for not putting 20% down, even if you can afford it, is that you’ll keep your cash free for other expenses. For example, if you are buying a fixer-upper, you can hold on to a large portion of cash and use it to improve the home; if you used your money as the down payment, you might end up borrowing to improve the home anyways. There’s a chance that the interest you pay on the home-improvement loan could be higher, which means you’d have to actually pay more.
If you decide down the road that you’d like to remove PMI, you can simply pay extra towards your loan to reach 20% equity, assuming 20% is the threshold for your specific loan (sometimes it’s 22%, 18%, etc.). At a later time, you can also refinance the home, which may allow you to get a better interest rate.
Fund Retirement Savings
Another area that you can fund with money that would otherwise go to a 20% down payment is your retirement funds. Because of the miracle of compound interest, starting your retirement investments early is critical, but if you pay a large down payment, you may have to delay investments in this area.
Retirement can come faster than you expect, and it’s easy to put it off, so you may want to consider saving some of your cash for retirement accounts. If you are considering this option, be sure to speak with an experienced investment professional before making any decisions.
If Surrounding Homes are Gaining Value Fast
There is actually an interesting scenario where you can literally gain equity without paying a large amount on the home. If you are finding that homes in your area are rapidly gaining in value, you could actually be gaining equity on your own home without even knowing it. You may, in fact, surpass 20% equity before making a lot of payments.
While the future is completely unpredictable, if prices for homes in your area have continued to rise, you could purchase a home with less than 20% down, wait for the value to rise, then refinance. If the home has gone up in value, you’ve automatically gained equity and could remove the mortgage insurance.
You Don’t Have 20%, But You’re Simply Ready to Buy
The other situation is when you simply don’t have the money but you are emotionally and financially ready to buy. (And yes, you can be financially ready without 20% down.) If your monthly expenses are in order, your income is solid, and you’re ready to invest in a property of your own, then maybe it’s time to consider homeownership. You may even benefit from down-payment assistance programs, which seek to enhance homeownership across the country. As long as you can reasonable afford the monthly payments, you are likely ready to purchase a home, with or without a 20% down payment!
Helping you Achieve the Dream of Homeownership
If you have questions about the importance of a down payment, contact the team at San Diego Purchase Loans. We’ll help you understand the pros and cons of a large down payment, and even show you options for buyers with less savings.
We believe that homeownership is important for everyone, so let us be a part of your future!