It’s the oldest personal finance advice in the book – don’t buy something if you can’t afford it. That wisdom is just as useful today as it was before the first dollar was ever minted.
But when it comes to the housing market, the notion of what’s “affordable” varies depending on who you talk to. Some people will tell you to not even start the house-hunting process until you have at least 20% saved for a down payment. Some say to put down as little as possible so you can start earning equity ASAP.
The truth, as always, is somewhere in between.
How much you should down on a mortgage depends entirely on your personal situation. It’s almost always better to put down as much as possible, but that amount can vary wildly from person to person. For some, a full 20% just isn’t in the cards – and neither is waiting long enough to save it.
If you’re confused on which direction to go, you’ve come to the right place. Read ahead for everything you need to know about picking the right down payment size.
Why a 20% Down Payment Is a Good Idea
Lenders don’t require a 20% down payment, but they definitely prefer one. The more a borrower can put down, the more stable they look in the eyes of the bank. Putting down more can have its benefits, but 20% is the industry standard.
A large down payment will result in a smaller monthly payment for two reasons: the mortgage balance will be smaller, and the lender will not charge you private mortgage insurance (PMI).
PMI is a kind of insurance the lender buys in case you stop making payments and default on the loan. Borrowers who put down less than 20% have a statistically higher chance of defaulting, so PMI protects them and their investment.
PMI can cost as little as .3% of the loan or as high as 1%. That percentage is calculated on an annual basis, paid monthly or in a lump sum each year. On a $200,000 mortgage, PMI can range between $50 and $166.67 a month.
Here’s the good news – PMI doesn’t stick around forever. Some loans are structured so that PMI automatically falls off once you have 22% equity in the home. You can also refinance once you reach 20% equity to remove PMI. You can usually speed that process up by increasing the home’s value with a few minor touch-ups, like adding in landscaping or repainting the outside.
Lenders also reward larger down payments with lower interest rates. As a general rule of thumb, the more you put down, the less you’ll pay in interest.
Mindy Jensen, Community Manager at BiggerPockets and author of “How to Sell Your Home,” said few people are aware of one of the biggest advantages of large down payments: the seller is more likely to accept your offer.
If a house has multiple competing offers, the seller wants to choose the one that has the highest chance of being approved by the bank. An offer that ends up falling through is a huge hassle for a seller – especially if they want to be out of the house quickly.
A small down payment has a greater chance of being denied than a traditional 20% down payment. In a city where houses are going like hotcakes, that can be a real problem.
To put it simply, borrowers who have a less-than-perfect credit score or a lower income can improve their chances of getting their dream home by putting down 20% or more.
“A larger down payment means you have more to lose,” Jensen said, “so with iffy credit, a larger down payment can be the difference between a yes and a no.”
When to Choose a Smaller Down Payment
For many people, putting down 20% means using up most, if not all of their savings. That can quickly become a problem if your new home needs renovations you don’t have the money to cover. No one should have to make the choice between a working toilet and on-time mortgage payments.
Shannyn Allan of The Wonder Luster made sure to have a solid emergency fund before buying her home.
“Everyone should balance that hefty down payment with a few grand in expenses from the things that inevitably break or were missed during inspection,” she said.
Another time when it’s ok to put down less than 20% is if you live in a hot market, like San Francisco or Austin. In areas like this, waiting too long will ensure your eventual buying price is much higher.
“Waiting to save up enough to avoid PMI could cost you thousands of dollars when you go to make the initial purchase,” Jensen said.
If you’re living in a hot market, it can also take you a long time to save up 20%. For example, the average house value where I live in Denver is almost $500,000 – so 20% of that would be $100,000. At my current savings rate, it would take me 4.6 years to get to $100,000. If I put 5% down, I’d only need $25,000, which would take 14 months to save up.
For many millennials, putting down 20% is next to impossible thanks to stagnating salaries, student loan payments and high home prices. It can take them until their mid-30s to save 20% – time they could spend earning equity in their own home. With rent skyrocketing across the country, plenty of young people can’t bear to wait any longer.
Down Payment Options
Fortunately, those who can only afford a small down payment have a number of mortgage options. Here are some of the most common:
Fannie Mae and Freddie MacFannie Mae and Freddie Mac-backed mortgages can require as little as 3% down, and there are few barriers to getting one. At least one of the buyers must be a first-time homeowner, it must be a single-family home, the buyer must live there full-time and the mortgage has to have a fixed interest rate.
You can ask your lender about applying for a Fannie Mae or Freddie Mac-approved mortgage.
Federal Housing Authority
Many consider an FHA loan the easiest type of mortgage to apply for, due to the low credit score requirements. Geared toward low-income buyers, those who choose an FHA loan can put down as little as 3.5% – as long as they have a credit score of 580 or higher. If your credit score is between 500 and 579, you’ll have to put down 10%.
However, FHA loans come with an annual mortgage insurance premium (MIP) tacked onto your monthly payment, similar to PMI. The MIP costs between .45% and 1.05%, depending on your total mortgage amount, the size of your down payment and the term length of your loan. The MIP doesn’t fall off automatically, so borrowers have to refinance if they want it removed.
If you’re a veteran or current servicemember, you may qualify for a VA loan with 0% down. You can also get your closing costs and other home-buying fees financed with your loan. Unlike FHA or other loans, VA loans don’t charge PMI or MIP fees.