This post is part 4 in a series of posts entitled “How to Buy a House” that outlines the basics of how to become a homeowner, including preparing your financial profile and credit to qualify, the process of applying for a mortgage, working with realtors to find a home, closing the deal, and any other great advice I can think of.
You can find all the other posts in this series by clicking here.
Once all your debt is paid off, the next thing is to start saving up for a down payment. How much you’ll need depends on the type of financing you select, but most people will need at least a minimum down payment of 3% to 5%. If you’re military active duty, a veteran, or in the reserves, you may not need a down payment at all.
Minimum Down Payments
The most common types of mortgage financing today are conventional, FHA financing, and VA financing. The following is a rundown of the minimum down payments required for each:
- Conventional Financing: You can buy a house with conventional financing with as little as 3% down (as long as you have strong credit), but you’ll get a better deal if you put down at least 5%. For loan amounts greater than $417,000, you may need to come in with at least 10%. Mortgage insurance will be required if you put down anything less than 20% of the purchase price, but you can request to have it dropped once the loan is paid down to 80% loan-to-value (LTV).
- FHA Financing: FHA guidelines require at least 3.5% down. Unlike conventional financing, however, you’ll be required to carry mortgage insurance regardless of how much you put down and you won’t be able to drop it when you pay the loan down to 80% LTV. Under the latest FHA guidelines, if you put down 10% or more you’ll have mortgage insurance for at least the first 11 years of the loan. If you put down less than 10%, the mortgage insurance will continue for the life of the loan.
- VA Financing: A VA purchase loan is probably one of the best mortgage deals available, but you have to be military active duty, a veteran, or in the reserves. If you’re eligible, you can buy a home with 0% down and no mortgage insurance (yes, you read that right!).
- HECM Reverse Mortgage: If you’re over 62 years of age, a reverse mortgage can be a great way to purchase a house. You’ll need to come in with around half of the purchase price as a down payment, but you’ll be able to live in the home for the rest of your life without a mortgage payment.
Though the lending guidelines may allow for a minimal down payment, I highly recommend bringing a larger down payment if you can. To me, debt equals risk, so if you can reduce the amount of debt you borrow, you’re taking on less risk for yourself. There’s also less risk for the lender, which means you’re likely to get a better deal.
The following are a few reasons why I recommend making a larger down payment:
- You’ll have a lower mortgage payment. If you put down more, then you’re borrowing less, which means you’ll have a lower payment. A lower payment means you’ll be better able to handle unexpected expenses or a loss of income.
- You’ll have more equity. Putting down more means you’ll have more equity in the property right out of the gate. This means there’s less risk of being upside down if home values fall in the future.
- You’ll get a lower rate and/or closing costs. If you have more equity in the deal, then it’s a safer loan for the lender, which means you’re likely to get a better deal.
- You’re more likely to get your offer accepted. For many of the reasons already mentioned, having a larger down payment means your offer is stronger because your financing is more likely to be approved.
- You may be able to take a shorter loan term. If you’re borrowing less, then you may be able to take a shorter loan term and easily afford the payment. Shorter loan terms pay off faster, build equity quicker, and often come with lower rates.
If can’t avoid mortgage insurance, coming in with a larger down payment is a good idea for a few additional reasons:
- You’ll have a lower mortgage insurance premium. Whether you’re taking a conventional or FHA loan, mortgage insurance premiums are calculated as a percentage of the loan amount. If you put more down, the loan amount will be lower, which makes your mortgage insurance premiums lower as well. In the case of conventional financing, mortgage insurance premiums are also tied to LTV. Putting down 5% instead of just 3% can result in a significant reduction in the mortgage insurance premiums you pay. The mortgage insurance premiums get lower with each 5% reduction in LTV until you reach 80% LTV, where the premiums go away altogether. For example, conventional mortgage insurance premiums are lower if the LTV is 90% instead of 95%. The same applies if the LTV is 85% versus 90%; you’ll get a lower mortgage insurance premium to reflect the reduced risk for the lender because you’re bringing more equity to the deal.
- You can get rid of mortgage insurance sooner: If you’re stuck with mortgage insurance, making a larger down payment means you’ll pay down the loan to 80% LTV sooner and be able to drop the mortgage insurance (assuming you don’t have an FHA loan).
Lenders like it when you bring a larger down payment to the closing table because it means you have more equity in the deal, which means less risk for the lender. And if there’s less risk for the lender, you’re likely to get a much better deal on the loan.
Don’t Forget Closing Costs
Though the lending guidelines allow for the minimum down payments above, you’ll still need additional cash to cover closing costs and escrow deposits. I recommend planning on having an additional 2% to 4% of the purchase price to cover these expenses. This doesn’t mean you’ll actually need to spend that much, but it’s better to have plenty of money set aside than not have enough to get the deal done.
Closing costs can vary widely from one area to the next, so for a better estimate in the area you plan to shop for a home, be sure to check with an experienced real estate agent or loan officer.
Using Gift Funds for a Down Payment
Another way you can raise cash for a down payment is through gift funds. Gift funds are a great way to increase your down payment, but it’s super important you handle and document them correctly or you could create some major headaches for yourself (and maybe get your loan turned down).
For more information about how to use gift funds for a down payment, check out my post on it here.
How Much Money Will I Need?
To get an idea of how much you’ll need for a down payment, I recommend researching the real estate market where you plan to buy and getting an idea of how much the average home in that area will cost. Once you have an idea of home prices, you can then determine how much you’ll need to save up for a down payment.
In an ideal world, you’ll always want to bring a 20% down payment to avoid mortgage insurance, but I realize this can be tough in areas where real estate is really expensive. If you’re planning to buy in San Jose, CA, for instance, a 20% down payment would be around $120,000 for a median-priced home. However, if you’re planning to buy in Louisville, KY, coming up with a 20% down payment isn’t so formidable.
And of course, if you’re able to qualify for VA financing, avoiding mortgage insurance is a non-issue. The size of your down payment will depend primarily on how much you want to spend and the max monthly payment you’re comfortable with.
The bottom line is that how much you’ll need to bring in for a down payment will depend on how expensive real estate is in the area you want to buy, how much you can save every month, and your time frame for purchasing a home. I recommend first going through your monthly budget and determining how much money you can reasonably save on a monthly basis. If you can save up $1,000/month and you live in an area where real estate is cheap, you can probably save up a 20% down payment in a very short time. However, if you live in an area where real estate is super expensive, then saving up 20% might take you the next 20 years, and it might make more sense to put down less.
The other factor you want to consider is payment affordability. Obviously, if you put down less, you’ll be borrowing more, which means you’ll have a higher monthly payment. Bankrate.com has a number of great mortgage calculators; put those to work for you to get an idea of how much your monthly payment will be based on various home prices and down payments. Bankrate is also a good resource for getting an idea of what kind of interest rates you can expect to pay for a mortgage.
To recap, there’s really no easy answer for how much you’ll need to save up for a down payment. Ideally, you want put down at least 20%, but whether or not you can do that depends on how much home prices are in the area you want to buy, how much you can save on a monthly basis, what payment you’re comfortable with, and your time frame for buying a home.
Whatever number you come up with, make sure to allocate extra cash for closing costs. These can vary widely depending on the area you plan to buy, but it’s a good idea to at least plan for an extra 2% to 4% of the purchase price. It doesn’t mean you’ll actually need to spend that much, but it’s better to have more than you need than not enough.
To firm up your estimates even more, check with an experienced real estate agent or loan officer.
Get on a Savings Plan
Once you have an idea of how much you’ll need to save up for a down payment, it’s time to get on a plan to make that happen. If you’ve already paid off all your debt, hopefully you have some free cash flow you can set aside in savings for a down payment. Figure out how much your current budget will allow you save every month, then divide that number into the amount you’ll need to cover a down payment and closing costs in the area you want to buy.
For example, if you want $20,000 for a down payment and you can save around $700/month, then you’ll need to save for around 28 months to build up the down payment you need.
If whatever time frame you come up with isn’t quick enough, then it’s time to figure out some extra ways to generate cash, either by earning extra income and/or by cutting expenses to accelerate your savings.
One way I mentioned in the last post was to start a side hustle to make extra income. I didn’t get into a lot of depth about how to do that, but the idea is to leverage the skills you have into a side gig that can earn extra money. For some ideas about how to do this, check out the following links:
Just as getting a side hustle helps pay down debt faster, it can also help you save up a down payment much faster. If you have skills that you can use on the side to generate extra income, by all means take advantage of them and put whatever you earn into your account for your down payment. There a lot of opportunities for freelancing online (check out Elance and Odesk) doing things like web design, writing articles, taking surveys, proofreading, etc.
Or, maybe you can buy and sell items on eBay and Craigslist. I personally know a guy that makes a very good living buying secondhand items from pawnshops, thrift stores, and garage sales and sells them on Amazon, Craigslist, and eBay. Get creative! You may find there are a lot of ways you can raise extra cash for your down payment.
Preparing to Qualify for a Mortgage
Once you’ve saved up a down payment, I recommend keeping the funds in a quiet account that gets very little deposit activity for at least 90 days in advance of applying for a purchase mortgage. Lenders will want to “source” and “season” the funds you’ll be using for your down payment, meaning they’ll want to document with bank statements that it’s been in the bank for at least 90 days.
It’s important to keep the funds in a quiet account with very little deposit activity to avoid some big paperwork headaches. If the bank statements you provide have a mess of unidentified deposits on them, which result from checks or cash you deposited or transfers from other accounts, then lender will require you to document them as well. Trust me, this is a headache you’d rather avoid! This means gathering up additional canceled checks, receipts, and bank statements and sending them into the underwriter. If the additional bank statements your provide also have unidentified deposits, you’ll be asked to document those as well. Again, this is a headache you want to avoid!
Deposit your down payment and closing costs into a very quiet bank account at least 90 days in advance of applying for new mortgage. Once you’ve done that, don’t make any new deposits into the account.
Be sure to check back in the coming weeks, I’m going to be getting into more about how to prepare yourself financially for home ownership. You can find all the other posts in this series by clicking here.