Down Payment Strategies

How to Choose the Best Down Payment

Down Payment Strategies
March 27, 2014

The standard down payment for most loans is 20% of the cost of the home, and that is often the best path if you can afford it. Mortgages with a lower down payment are available, but this will generally raise your overall costs. Also, most require private mortgage insurance (PMI) as an extra level of security against default. PMI adds to your overall costs regardless of how it is incorporated; it typically runs a little over 2% of the cost of your home.

So, the first step is to ask: if you do not have enough funds available for the 20% down payment, are you really ready to buy a home, or are you buying more home than you can afford?

Many mortgage calculators online can help you to test different scenarios of down payment amount, loan type, and mortgage amount so you can see the effect of your choices on monthly payments and overall costs. You may decide that it is worth waiting and increasing your savings and/or altering your spending habits to make monthly payments more affordable.

If you decide to proceed anyway, let’s look at some down payment options.

  • Conventional Loan With PMI – Loans backed by Freddie Mac/Fannie Mae can handle down payments as low as 5%, but will require PMI. Most people make monthly PMI payments, but you can add it to the mortgage amount, or pay it upfront if you have the funds. Adding PMI to the mortgage total makes the payment deductible.

    If you go with monthly payments, consider making a periodic extra payment to the principal to build up equity and get rid of PMI more quickly.

  • FHA Loans – FHA loans can take as low as 3.5% with decent credit scores, but in this case, you will have to pay an upfront mortgage premium as well as PMI.

  • VA Loans – If you are a veteran and qualify for VA loans, they are an excellent option. They require no money down and no PMI, but they do require a funding fee that is in the same range as PMI.

  • Piggyback Loans – It is possible to do partial “piggybacking” with 10% down payment, 80% primary mortgage, and 10% second mortgage at a higher, usually adjustable interest rate. Going this route avoids PMI, but you will have to compare second mortgage terms to a 10% down plus PMI arrangement to see what is more economical for you.

Instead of looking for alternate low-down-payment loans, you may also consider alternate ways of acquiring 20% down money.

  • Gifts – Friends or relatives can give your down payment to you, but it is very important that it be a gift and not a loan. Your benefactor will have to fill out a letter explicitly stating that the money is a gift and not to be repaid, and provide a paper trail for proof.

  • Retirement Plans – This is generally not the best way to go. Unless you have a Roth IRA, there are significant costs associated with drawing from retirement funds – taxation, penalties, or both. In some cases you can borrow from a 401(k) program, but you must be careful on the repayment rules – check with your employer on your options.

While there are options for lower down payments, most come with significant drawbacks. You are generally better off waiting until you can save 20%, but if circumstances dictate it – for example, if interest rates are increasing and you want to lock in a lower fixed rate – you at least have some options to consider.

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