Looking to buy a home? One of the first things you need to do is save up enough money to be able to make a down payment of at least 20 percent of the purchase cost, right?
Errr...no. No, you don't. Not at all.
While there are a lot of good reasons to make a 20 percent down payment if you can afford to do so, it's far from a requirement to qualify for a mortgage, even in today's tight lending environment. There are many lending programs that will allow you to buy a home with as little as 5 percent down or less - you can still even get a mortgage with no money down if you can qualify for the right programs, such as a VA or USDA loan.
Echoes of the crash
It's not surprising that the myth of the 20 percent down payment remains so strong. Certain financial writers, mindful of the excesses of the previous decade, continue to insist on the necessity of 20 percent down, though this is their own recommendation and far from a hard-and-fast rule. And while this is a very solid and safe approach to housing finance, it's not without downsides of its own, as we'll discuss later.
Lenders did severely tighten mortgage credit in the wake of the downturn. But even then certain low down-payment programs remained, notably the FHA with its 3.5 percent down payment minimum and VA loans, which allow no-money down mortgages for those who qualify.
And if you're buying a high-priced home that will require a jumbo mortgage, don't be surprised if lenders do insist that you put 10-25 percent down. But if you're shopping in that end of the market, a small down payment probably isn't a major priority.
Types of low-down payment loans
So what are some of your options for a low-down payment mortgage?
We'll start with the FHA, which is the most prominent of the low-down payment programs. As noted above, you can make a down payment of as little as 3.5 percent of the purchase price on FHA loans. Not only that, but you don't need a great credit score either.
At least one major lender, Wells Fargo, has indicated it will approve FHA mortgages with credit scores as low as 600 and some other lenders will go even lower than that. Of course, a lower credit score means a higher interest rate and fees - but that's true of any mortgage type, not just FHA loans.
The major downside with an FHA loan is that, while the interest rates are quite competitive, the fees are fairly high. That's particularly true of the up-front and ongoing fees charged for mortgage insurance, which is required on most types of mortgages with less than 20 percent down. Furthermore, if you put less than 10 percent down you have to carry mortgage insurance for the life of the loan; on a conventional mortgage, you can cancel it once you reach 20 percent equity.
Fannie and Freddie
The most popular mortgages are those backed by Fannie Mae or Freddie Mac, known as conforming loans. Many borrowers assume they'll need a large down payment to get one of these but in reality, they've been offering mortgages with as little as 5 percent down for some time. Not only that, but they've also announced plans to go as low as 3 percent down, likely in early 2015.
The big advantage of a Fannie Mae or Freddie Mac mortgage is that their fees are considerably lower than on FHA loans. You'll have to pay for private mortgage insurance if you put less than 20 percent down, but this is cheaper than the insurance on comparable FHA loans. Not only that, but you can cancel it once you reach 20 percent equity; to do that on an FHA loan, you'd need to refinance.
The problem with conforming loans is that their credit requirements are considerably higher than on FHA loans; currently, the average credit score on approved Fannie/Freddie mortgages is in the mid-700s, compared to the upper 600s for FHA mortgages. That's not a problem if you've got excellent credit, but could be an issue otherwise.
VA and USDA
If you're a qualifying veteran, active duty member of the military or in one of several other service-related categories, you probably know you can generally get a VA loan with no money down up to a certain dollar limit. However, what many people don't know is there's another federal program that offers no-money down mortgages for non-military families.
USDA Rural Development loans are mortgages for people with moderate incomes who currently lack adequate housing. They cover the purchase of modest homes in non-metropolitan areas, which can include small towns and even many suburbs. It's a popular program, so there's often a waiting list. Not all lenders offer USDA loans, so the best place to start is to contact the USDA or visit the agency's web site to find the name of a lender near you.
Are small down payments risky?
So yes, there are multiple options out there for low-down payment mortgages. But you may be asking yourself, if buying a home with so little down is really such a good idea. After all, isn't that how a lot of people got in trouble during the housing bubble?
Well, yes and no. A lot of people bought homes with little or no money down back then, and when housing prices collapsed, they didn't have any equity cushion to protect them against foreclosure. Although for many, the bigger problem was that they'd taken out mortgages with escalating monthly payments they couldn't afford, or that they simply couldn't make payments at all after losing their jobs in the downturn.
In reality though, a substantial down payment may provide only temporary protection. If a financial crisis comes along where you can't afford your mortgage payments, having equity may put you in a position where you can sell the home rather than going to foreclosure, but the bottom line is still that you're losing the property. Your credit won't take quite the beating it would in a foreclosure, but if you fall a few months behind on your payments, it will take a hit anyway.
To be sure, a down payment of 20 percent or more will help you get the best deals on mortgage rates and fees, as well as allowing you to avoid paying for mortgage insurance, the cost of which is like raising your mortgage rate by one-half to a full percent or more. So some financial advisors suggest it's best to wait until you have 20 percent in hand before buying a home.
Bear in mind, however, that it takes most people an awfully long time to save up that much money - often a couple of decades. Meanwhile, you're spending money on rent that could be going toward mortgage payments. In 20 years, you could be two-thirds of the way toward paying off a 30-year mortgage, rather than just getting around to making your purchase.
You also have to take into account the possible opportunity cost. Mortgage rates are still near their all-time lows and remain exceptionally low by historical standards. Waiting a few years to assemble a larger down payment could mean you'll be looking at much higher rates - and a steeper monthly payment as well.
Overall, if you've got a steady job and take out a fixed-rate mortgage where your payments will never increase, there's no reason to be overly concerned about taking out a loan with a small down payment. If you have the financial resources and can afford it, there can be advantages to making a larger down payment. However, you need to look at your own financial situation, add up the pluses and minuses of the two options and decide what makes the most sense for you.