When you buy a home, one of the biggest up-front expenses is the down payment. Not to be confused with closing costs, the down payment is the portion of the purchase price that you pay up front at closing. Generally, if you put less money down on a home at closing, you’ll pay more in fees and interest over the loan’s lifetime (and vice versa).
The amount you designate as a down payment amount helps a lender determine how much money to loan you and what type of mortgage is best for your needs. But how much is just the right amount for a down payment? Paying too little will cost you in interest and fees over time. Too much could deplete your savings or negatively affect your long-term financial health. Plus, you still need to factor in closing costs, moving expenses and other monthly bills. Ultimately, the size of your down payment depends on you: Your savings, income, and your budget for a new home.
First, you need to figure out your budget and how it can impact your down payment. Investopedia’s free, online mortgage calculator helps you calculate your monthly mortgage payments and make the right financial decisions when buying a house. One of the fields asks for an estimated down payment amount.
How Much House Can You Afford?
When you get preapproved for a mortgage, a lender will tell you the maximum loan amount for which you qualify, based on responses in your application. Your mortgage application asks about your estimated down payment amount, income, employment, debts and assets. A lender also pulls your credit report and credit score. All of these factors influence a lender’s decision about whether to loan you money for a home purchase, how much money, and under what terms and conditions.
As a general guideline, many prospective homeowners can afford to mortgage a property that costs between 2 and 2.5 times their gross income. For example, if you earn $100,000 per year, you can afford a house between $200,000 and $250,000.
Rather than simply borrowing the maximum loan amount a lender approves, you’re better served evaluating your estimated monthly mortgage payment. Say you get approved for a $300,000 loan. If your monthly mortgage payment and other monthly debts exceed 43 percent of your gross monthly income you might have trouble repaying your loan if times get tight. In other words, be cautious about buying more house than you can reasonably afford.
If you’ve been renting for some time, or you already own a home and are looking to buy again, you likely have a strong handle on the monthly mortgage payment you can afford. Renters should keep in mind that owning a home or condo includes additional expenses such as property taxes, maintenance, Home Owners Association (HOA) dues, and unexpected repairs.
Beyond buying a house, you may also want to contribute to other financial goals like saving for retirement, starting a family, shoring up an emergency savings fund, and paying down debt. Taking on a too-high monthly mortgage payment will eat up cash that could otherwise go toward some of these important goals.
Down Payment and Your Loan-to-Value Ratio
Your down payment plays a key role in determining your loan-to-value ratio, or LTV. To calculate the LTV ratio, the loan amount is divided by the home’s fair market value as determined by a property appraisal. The larger your down payment, the lower your LTV (and vice versa). Since lenders use LTV to assess borrower risk and price mortgages, a lower LTV means you pay lower interest rates on your mortgage – and may avoid additional costs.
A lower LTV ratio presents less risk to lenders. Why? You’re starting out with more equity in your home, which means you have a higher stake in your property relative to the outstanding loan balance. In short, lenders assume you’ll be less likely to default on your mortgage. If you do fall behind on your mortgage and a lender has to foreclose on your home, they’re more likely to resell it and recoup most of the loan value if the LTV ratio is lower.
In addition to assessing your risk, lenders use the LTV ratio to price your mortgage. If your LTV ratio is lower, you’ll likely receive a lower interest rate. But if the LTV ratio exceeds 80 percent, meaning you’ve put less than 20 percent of the home’s value as a down payment, expect higher interest rates. These rates cover the lender’s increased risk of loaning you money.
Also, if your LTV ratio exceeds 80 percent, you’ll likely pay for private mortgage insurance, or PMI. The amount of PMI you’ll pay depends on your loan type. For instance, some loans insured by the Federal Housing Administration require an up-front mortgage insurance premium that’s paid at closing, as well as annual mortgage insurance premium (MIP) for the life of the loan. While FHA loans have a low, 3.5-percent down payment requirement, the total cost of borrowing money as calculated in the annual percentage rate tends to be much higher for these loans.
How Your Down Payment Impacts Your Offers
When you’re on the hunt for the right home, time is of the essence. Homes in entry-level price ranges typically sell quickly, and you want to put your best foot forward when making an offer because you’ll probably have competition. When markets are competitive and sellers receive multiple offers, they want to see buyers’ best offers, including a sizable down payment. From a seller’s viewpoint, buyers who have more money to put down are more attractive because they have more skin in the game.
A higher down payment can indicate to a seller that you have enough cash on hand and solid finances to get a final loan approval (and get to the closing table) without a hitch. Also, a higher down payment could beat out other offers that ask for sellers to pay closing costs or offer below asking price. Someone with a sizable down payment is unlikely to request such assistance, and sellers are more likely to work with a buyer who has the money and motivation to see the purchase through with minimal haggling.
Low Down Payment Loan Programs
In years past, homebuyers were convinced they needed 20 percent down to buy a home, but times have changed. Many homebuyers, especially first-time buyers, simply don’t have a 20 percent down payment saved. This is becoming increasingly the case as home prices soar in many U.S. housing markets. For example, the median existing-home price in January 2018 was $240,500, an 5.8 percent increase from $227,300 in January 2017, according to the National Association of Realtors.
In fact, homebuyers who financed their home put down an average of 10 percent of the purchase price, according to NAR’s 2017 Profile of Home Buyers and Sellers. First-time buyers using financing typically put down just 5 percent of the purchase price, the survey found.
For those who can’t afford a 20 percent down payment, several types of mortgages offer a low down payment option.
Fannie Mae and Freddie Mac programs (3 percent down)
Fannie Mae and Freddie Mac, government-sponsored enterprises that buy and sell most U.S. mortgages, require only 3 percent down for borrowers with strong credit. Both programs will consider some borrowers with no credit score by building a non-traditional credit report – as long as those borrowers meet certain debt-to-income and loan-to-value ratio guidelines in addition to other requirements. Fannie Mae’s HomeReady mortgage program allows a 97 percent LTV ratio for borrowers with a minimum credit score of 620. Freddie Mac’s Home Possible Advantage mortgage also offers a 97 percent LTV ratio for borrowers, but requires a minimum credit score of 660 to qualify.
Individual lender programs (1 to 3 percent down)
Many lenders offer Fannie Mae and Freddie Mac’s programs, and add their own down payment assistance benefit for a conventional loan. For example, Guild Mortgage requires 1 percent down and provides a 2 percent gift for borrowers with qualifying low incomes and a minimum credit score of 680. Wells Fargo’s yourFirst Mortgage allows for 3 percent down with no area median income requirements. These are only two of many options. If you need a loan with a low down payment requirement, ask lenders about their offerings to help you narrow down your choices.
Jumbo loans (10 to 20 percent down)
Jumbo loans are the most common type of non-conforming conventional loan available to homebuyers. Lenders have varying qualifying guidelines for jumbo loans, which exceed an area’s conforming loan limit set by the federal government. Because jumbo borrowers present more risk for a lender, expect to put 10 to 20 percent of the purchase price down. Borrowers with credit scores of 700 or higher tend to get the best pricing, but some lenders will work with jumbo borrowers with a minimum score of 660. Lenders might require you to have 10 percent of the home’s purchase price in cash or other assets in case you run into issues repaying your mortgage.
FHA loans (3.5 percent down)
You can put as little as 3.5 percent down on FHA loans if you have a minimum credit score of 580. FHA-approved lenders also will consider borrowers with non-traditional credit histories as long as you’ve had on-time rent payments in the past 12 months, no more than one 30-day late payment to other creditors, and you haven’t had any collection actions (medical bills being the exception) filed in the last 12 months. Also, the property you’re buying must comply with the property standards set by the U.S. Department of Housing and Urban Development for single-family and condo homes, and be within FHA loan limits. Another benefit of FHA loans is that you can use a financial gift from a relative or friend toward all or part of your down payment, if you provide documentation stating it’s a gift and not a third-party loan.
VA loans (0 percent down)
U.S. military service personnel, veterans and their families can qualify for zero-down loans backed by the U.S. Department of Veteran Affairs. Other benefits include a cap on closing costs (which may be paid by the seller), no broker fees, and no MIP. VA loans do require a “funding fee,” a percentage of the loan amount that helps offset the cost to taxpayers. The funding fee varies depending on your military service category and loan amount.
USDA loans (0 percent down)
The U.S. Department of Agriculture guarantees loans to help make homeownership possible for low-income buyers in rural areas nationwide. These loans require no money down for qualified borrowers — as long as properties meet the USDA’s eligibility rules.
Down Payment Assistance Programs
Special programs in your state or local housing authority offer help to first-time buyers. Many of these programs are available based on buyers’ income or financial need. These programs, which usually offer assistance in the form of down payment grants, can also help with closing costs. The U.S. Department of Housing and Urban Development lists first-time homebuyer programs by state. Select your state then “Homeownership Assistance” to find the program nearest you.
4 Ways to Save More for a Down Payment
It can be a challenge to save money for a down payment on a home. Here are some quick tips to get you there:
- Start early with an automated plan. In addition to a regular savings or emergency fund account, open a dedicated savings account for your down payment. After each pay period or windfall (like a financial gift, tax refund, bonus or inheritance), deposit money into your down payment fund and watch the balance grow over time. Contributing to that fund as early and often as possible will help you stay on track.
- Slash your spending. If homeownership is important to you, cut out or reduce unnecessary expenses such as cable and TV service, eating out, vacations or other non-essentials. By spending less, you’ll save more toward your down payment and have extra money to pay down other debts. Making sacrifices now can go a long way toward achieving your homeownership goals.
- Pay off high-interest debts. Credit cards or loans with high interest rates can hurt your credit and are costly in the long run. Focus on paying down these accounts first, and you’ll see a snowball effect on reducing your debt. Once these accounts are paid off, you can then apply the monthly payment amounts toward your down payment savings. However, don’t close these accounts; that can lower your credit score because you’re losing an open line of credit and an account history. Instead, use them minimally (buy gas or an occasional dinner at a restaurant ), and pay the balances off immediately. This behavior helps bolster your credit payment history and shows responsible usage to credit bureaus and lenders.
- Get a second job. Many first-time buyers find they can save much faster if they increase their income. Finding side gigs to do from home or working a seasonal retail job can help increase your down payment savings. Even if you work temporarily for six months or a year prior to buying a home, the added income could be the boost you need for a decent down payment.
The Bottom Line
It’s not impossible to buy a home if you don’t have much cash saved up for a down payment. Shopping around for the right lender and loan type is a critical step. With a lower down payment, expect to pay higher loan fees and interest rates, as well as PMI. Also, don’t forget to tap into down payment assistance programs offered by your state or city. If someone offers a financial gift toward your down payment, make sure they understand it cannot be a loan. Finally, there’s no shortcut to saving for a down payment: it takes time, discipline and effort. But the result – purchasing a home of your own – can be rewarding, both financially and personally.