How Much Should Your Down Payment be for Your Mortgage?
Buying a home is a big step. For most of us, it’s the biggest purchase we’ll make, and with it comes a bag full of questions we’re often too afraid to ask because we’re made to feel as if we should already know the answers.
How much should your down payment be for your mortgage? This is a question that’s asked frequently, and it’s an important one to know the answer to because it means you’ll go into a meeting with your lender prepared. It’s a question you’ll hear from your lender, and they’ll expect an answer because knowing how much you’ll put as a down payment will dictate your home mortgage loan. However, it’s also more than that - how much you can save and feel comfortable parting ways with for a down payment can mean buying your dream home or not.
What’s a Down Payment?
You’re new to the home-buying market - that’s ok! Let’s then start at the beginning. A down payment is your first step, really. It’s the cash you put upfront to obtain a home loan and it’s deducted from the total amount of your mortgage. When you place your down payment, it marks the beginning equity, which is your ownership, in your house and its property.
A sizable down payment can also represent your commitment to buying the home. To a seller, your down payment demonstrates monetary proof that you’re invested, both financially and otherwise, in purchasing their home. It shows you’re serious, and it can help separate you from the rest of the potential buyers clamoring for the same home.
If you’ve been doing your research on the ins and outs of buying a house, you’ve probably heard that it’s common to put down 20% of the sales price of the home as your down payment. Is the mythos in fact true?
Although you may not want to give up 20% upfront for a down payment, the truth of the matter is that lenders prefer this percentage for a down payment. For a $300,000 home, that’s $60,000 and that is undoubtedly a lot of money. The perk is you’ll be getting a better mortgage interest rate, which we’ll get into later.
When lenders make a loan, they use calculations and ratio models along with basic criteria to determine your creditworthiness like your credit score and credit reports. The loan-to-value ratio is the percentage of the home’s value you will owe after you have made the down payment on it. The formula is the mortgage loan amount divided by the appraised value of the house you’re purchasing. An example of a loan-to-value ratio is a house with a price of $100,000, your down payment of $10,000 and your home loan for $90,000. Your LTV ratio is then calculated at 90%.
Why do lenders lean towards this 20% down payment percentage? It all boils down to risk. As you know, 20% is a big chunk of change, and that takes a lot of out of worry about a borrower defaulting on a mortgage loan down the road. Lenders see the greater the down payment, the less risk in their borrower. It’s an equation that’s led them to the industry “standard” of a 20% down payment.
The Benefits of a 20% Down Payment
A 20% down payment is a lot of money, no matter which way you slice it. A house that costs $100,000 has a 20% down payment of $20,000. A house with a price tag of $200,000 would require $40,000 for a 20% down payment. Keeping in mind that houses with different values are priced accordingly to the areas they’re in. No matter how “cheap” or “expensive” a house may seem, the cost of living still holds true to the idea that a 20% down payment is a good piece of a person’s savings. This begs the question, what does a homebuyer get out of putting down 20% of the house’s sales price, exactly?
Fortunately, it’s not just the lenders who benefit from the down payment. On the other side of the coin is you - the borrower. The down payment you put up for the home directly impacts the total cost of the home, significantly so. The larger that down payment is, the lower the interest rate you can get, which in turn will allow you to pay less for your home over your loan’s lifetime of payments.
Paying less in interest is a huge advantage for homebuyers and having a chance to land a lower mortgage interest rate is key in doing so. That brings you back around to the 20% down payment, which can help get you there. A 20% down payment does bring a few additional advantages, too.
Lenders are looking for minimal risk. If you can’t afford much in the way of a down payment, you will end up paying for it one way or another, specifically, in mortgage insurance. You’ll see an upfront fee and ongoing charges that are lumped in your monthly house payments. If the lender doesn’t require mortgage insurance, they’ll ensure their risk in issuing you the loan one way or another. Other instances classify these securities as “upfront guarantee fees” or “funding fees.” The higher the risk the lender sees you as the higher the interest rate for your loan’s lifetime and the more fees you’ll have to pay.
Your 20% down payment can skirt all around these fees and charges because lenders won’t view you as a risk, but rather as a creditworthy borrower. Lenders are required to disclose all of their fees, so you’ll know ahead of time what you’re getting into. The general rule of thumb indicates that a down payment of 20% is a good starting place to secure a low interest rate and avoid the barrage of fees and miscellaneous charges.
Low Down Payment Options
The fact is that 20% is a lot of money and not all of us have that kind of savings to part ways with to buy a home. Fortunately, there are programs and agencies that recognize this dilemma.
You can actually buy a home with a down payment as little as 3%, but naturally, there are exceptions and regulations that come with this low down payment. It can be done through the U.S. Federal Housing Administration (FHA) loan, which only requires homebuyers to put down 3.5% on a 30-year fixed-rate home mortgage. Other government-sponsored companies like Fannie Mae and Freddie Mac also allow for 3% down on home loans.
If you’re retired or an active service member, you could qualify for programs offered through the Department of Veterans Affairs, or for rural homebuyers, there are loan options available through the Department of Agriculture’s Rural Development program. Additionally, some conventional lending institutions like banks and credit unions will approve loans of certain amounts with down payments of 5%, usually in the range of $417,000. However, you’ll have to read their fine print when it comes to fees and private mortgage insurance.
A Bigger Down Payment Means Better Benefits
Ultimately, the more you put down on your dream home, the more advantages you’ll get in return:
You’ll pay less for your home in the long run
You’ll be able to get a lower interest rate for your mortgage loan
Sellers will see you as more committed, strengthening your chances in securing your dream home
You could avoid paying private mortgage insurance and other fees and charges