One of the most persistent myths about buying a home is the notion that you need to, or at least should, put 20 percent down. The truth is, you don't need anywhere near that much.
True, there are certain advantages to making a down payment of at least 20 percent down if you're in a position to do so. But holding off on buying a home until you've saved that much is not only unnecessary, it will likely end costing you more over the long run - perhaps a lot more.
The idea that you need to or should put at least 20 percent down when buying a home came out of the Great Recession, when credit dried up and for a while it really was very difficult to get a mortgage with less than 20 percent down.
Even as credit eased and lenders began accepting smaller down payments again, a chorus of financial advisers continued to insist that no one should buy a home unless they could put at least 20 percent down, to guard against buying a home you couldn't afford.
These days, there are numerous options for getting a mortgage with low down payments, even if you have mediocre credit. And while there are certain advantages to putting 20 percent down, a down payment of that size doesn't protect you as much as it does the lender in the event of a default.
Better terms vs. opportunity cost
The main reason for putting 20 percent down or more when you buy a home is that it allows you to get better terms on a mortgage. The biggest advantage is that it allows you to avoid having to pay for mortgage insurance, an extra charge which typically runs from 0.5-1.0 percent of your loan amount per year. It also enables you to get a somewhat lower mortgage rate, perhaps an eighth to a quarter of a percent lower than a comparable borrower with a smaller down payment might get.
But while a mortgage with 20+ percent down payment has lower costs, that doesn't necessarily mean it's to your advantage to wait until you can save up that much to buy a home. First of all, bear in mind that mortgage rates have been at historic lows these past six years. No one knows how long these low rates will last, but eventually they will move higher. When that happens, the rate and fees for a mortgage with 20 percent down could very easily exceed what you'd pay for the same loan today with 5-10 percent down, including mortgage insurance.
Not only that, but you're still paying rent during all that time you're trying to save up a down payment. Given that it would take the average person 10-15 years to save up enough for a 20 percent down payment on a starter home, that's a lot of rent you could be putting toward home ownership. And you could be one-third to halfway to paying off a mortgage in that time.
Is a small down payment riskier?
What about the argument that it's risky to take out a mortgage with less than 20 percent down? Well, it is - for your lender. The reason lenders like to see at least 20 percent down is that it gives them a cushion in case the property goes into foreclosure and they have to sell it for less than what you paid for it. Unless housing prices collapse, 20 percent gives them a pretty good margin and even means they'd likely come out ahead if you default on the loan.
From your end, though, ask yourself this: if for some reason you do end up defaulting and lose the home to foreclosure, what would you rather do: lose the 3.5 percent you put down on an FHA loan or the 20 percent down payment you'd been saving up for years? Which seems like the less risky approach to you?
On the plus side, a 20 percent down payment does give you a bit of a cushion if you find yourself in financial difficulty and unable to make your mortgage payments. In that event, you can likely sell the home and perhaps even get a bit of cash back, and protect your credit in the process. With only 3-5 percent down, your equity might be eaten up by closing costs and you might even have to put in some extra money as well.
Even if you default on a mortgage with a small down payment, your lender is still protected. That's where mortgage insurance comes in. It covers the difference between your down payment and 20 percent of the purchase price in the event of a default. That's what you're paying for.
There are some situations where you will have to come up with at least 20 percent down, though. If you have poor credit - say a score below 600 - a lender may require that much just to approve a mortgage in the first place. Many jumbo mortgages - high-value loans too large to be guaranteed by Fannie Mae, Freddie Mac or the FHA - may require 20 percent down or more. And if you go into non-agency lending - loans that otherwise fall outside of Fannie/Freddie/FHA guidelines - you'll likely have to make a down payment of at least 20 percent and often more.
Options for small down payments
If you're looking for a mortgage with a small down payment, what are your options? The following are some of the main ones.
FHA home loan
This is the classic low-down payment mortgage. FHA mortgages require only 3.5 percent down, and are available through most mortgage lenders. In addition, they have less stringent credit requirements than on many other types of mortgages, and offer better interest rates for borrowers with flawed credit. The downside is that you may have to pay more in fees than on other types of mortgages, and that you have to carry mortgage insurance for the life of the loan if you put less than 10 percent down. Still, they're a good choice for borrowers who are just beginning to establish their credit or who have some blemishes on their credit history.
Fannie Mae/Freddie Mac
Often referred to as "conventional" or "conforming" mortgages, these are the most common types of home mortgages in the United States. Fannie Mae and Freddie Mac do not make loans themselves, but provide backing for loans that meet certain standards. Some lenders offer Fannie/Freddie mortgages for as little as 3 percent down, though 5-10 percent minimums are more common. Credit standards are higher than on FHA loans, but Fannie/Freddie mortgages often offer better terms for borrowers with good credit.
For those who meet the eligibility requirements, VA loans are hard to beat. Veterans and others with certain types of military affiliations can purchase their first home with no money down in most cases and can often do so on subsequent properties as well. Interest rates and other terms are very attractive, making VA loans the preferred choice for most eligible veterans looking to buy a home.
USDA Rural Development Loans
Though somewhat obscure, this federal program offers mortgages with 0 percent down to eligible borrowers. There are a number of restrictions, however - eligibility is income-based, homes purchased must be modestly priced and borrowers must currently lack adequate housing. Homes purchased under this program technically must be in rural areas, but the definition includes many small towns and suburbs; "non-urban" may be a more accurate description. Funds for this program are limited and there may be a waiting list. The number of lenders offering these loans is relatively small; check with your closest USDA office to find one serving your area.
State and Local Housing Agencies
Though they aren't actual mortgage programs, many state and local housing agencies offer down payment assistance programs to help borrowers obtain the funds needed for a down payment on a home. These may be in the form of loans, grants or other assistance that varies by location. Check with your state or local housing agency for more information.
In addition, the U.S. Dept. of Housing and Urban Development (HUD) offers a "Good Neighbor Next Door Program" that allows members of certain public-service professions to obtain mortgages with only $100 down. Eligible professions include police, firefighters, EMTs and K-12 teachers. Homes purchased must be in certain targeted neighborhoods to be eligible.