John and Mary plan to buy a home. Their credit is okay, but not excellent. They have some money put away toward a down payment of about 20 percent of the value of the home they want to buy. Meanwhile, Joe and Nancy have excellent credit, but have very little money put aside for a down payment on the home they wish to purchase. Which couple will get a mortgage loan?
The answer may surprise you. Both couples may be able to find a mortgage that will fit their needs, even though their down payment amounts vary greatly. This guide explains what you need to know about how down payments work.
What is a standard down payment?
Convention wisdom once held that the standard benchmark for down payments is 20 percent of the purchase price of your new home. The average purchase price of an American home is $186,000 (source), meaning that, to reach the 20 percent threshold, the typical American family would have to cough up $37,200 in order to get a mortgage loan.
In reality, however, mortgage lenders now accept a wide range of down payments. Recent data suggests that the average down payment is 14 percent nationwide (source). A lender’s openness to working within a borrower’s means allows many people who might not otherwise qualify for a mortgage to get one. That is good news for anyone in the market for a new home.
What is the lowest down payment you can make?
The answer to this question depends on the type of mortgage loan you get, your creditworthiness, and the purchase price of your home.
For instance, if you are a veteran, you may qualify for a VA loan, which requires no down payment at all. What if you are not a veteran?
The U.S. Department of Agriculture also offers a 0 percent down payment option for homes designated as rural by the USDA. However, this loan has some fairly tight restrictions regarding qualifying income-to-payment ratios and location. So, unless you have somewhat unique circumstances, you may not be eligible for a USDA loan.
Fannie Mae offers a Conventional 97 Loan and a HomeReady™ mortgage that only requires a 3 percent down payment.
FHA loans require a minimum of 3.5 percent down for loans up to $417,000. However, FHA loans come with a monthly mortgage insurance payment (MIP), which will increase your monthly mortgage payment.
Conventional loans give you a variety of down payment options to explore. If you have excellent credit, it may be possible to get a conventional loan with a down payment as low as 5 percent. These loans also require you to carry private mortgage insurance. However, the good news is that after you have accumulated at least 20 percent equity in your home, you can eliminate the private mortgage insurance altogether. More on that later. Other typical down payments for conventional loans are 10 percent down, 15 percent down, or 20 percent down.
The loans backed by the U.S. government adhere to strict standards regarding down payment amounts. However, if you find a conventional loan that is not backed by the government, your lender may be willing to negotiate your down payment amount.
What is a loan-to-value (LTV) ratio, and how does it affect your down payment?
Your loan-to-value ratio (LTV) is a comparison between the balance of the loan you want and the current value of the house you buy. Lenders establish the value of your home by one of two methods. They use the appraised value of your home, or they use the purchase price. Typically, the value they will assign to your home is the lesser of the two.
To determine your LTV, your lender will divide your loan amount by the value of your home. The resulting ratio is your LTV. For instance, suppose you are purchasing a home with a value of $200,000. If you are trying to get a loan for $180,000, your LTV is 90 percent.
Generally, the lower your LTV is, the better your interest rate will be. Why? Lenders consider loans for borrowers who have a lower LTV as less risky because those borrowers have more equity in their homes. Lenders work on the assumption that borrowers with a lower LTV and more equity in their homes are less likely to default on their mortgage. Even if such a borrower does default, the lender has a better chance of selling the home in foreclosure for at least as much as the outstanding balance on the mortgage.
Your down payment affects your LTV. The larger your down payment is, the lower your LTV will be. Remember that the lower your LTV is, the lower your interest rate will be and the more likely you are to get the loan you want.
How do down payments affect Private Mortgage Insurance (PMI)?
Private mortgage insurance (PMI) is mortgage insurance from private insurance companies required for conventional loans with an LTV of over 80 percent. PMI protects the lender if you stop making mortgage payments on your home. Typically, the cost of PMI is an addition to your monthly mortgage payment just as property taxes and homeowners insurance are.
Lenders do not require you to pay PMI if your LTV is below 80 percent. This means that if you can make a down payment of 20 percent, you will not incur the added expense of PMI. If you cannot make a down payment of 20 percent, you will have to pay PMI until you have an LTV of 80 percent or less.
How much do you save in interest for every dollar you spend on a down payment?
While there is no set answer to this question, here are a few things to consider. If a larger down payment helps you get a lower interest rate, you will save thousands of dollars over the course of your loan. However, if a larger down payment does not change your interest rate, you might not be saving as much as you think.
For instance, suppose that you are buying a home valued at $200,000.
- If you finance the entire $200,000 at an interest rate of 6 percent for 30 years, your mortgage payment will be around $1,199 a month and the total cost of the mortgage will be $431,676.
- If you make a down payment of $20,000 on the same loan, your monthly payments will be $1,079 and the total cost of the mortgage would be $388,509. A saving of $43,167 in interest.
- A down payment of $40,000 would bring the monthly payments down to $959 and the overall cost to $345,341. That’s a saving of $86,335 in interest.
That does not include home insurance, property taxes or the PMI. Private mortgage insurance typically costs 0.5% to 1% of the mortgage balance a year. For this example, the PMI would cost between $83.3 and $166.7 per month. If you make a $20,000 down payment, you would save $1,000 to $2,000 a year in PMI payments in addition to what you save in interest.
Break-even point and opportunity cost
The changes in those monthly payments are nice to consider, but you also have to realize how long it will take to reap the savings of making a larger down payment.
The break-even point, or the point at which you are actually save money by paying a $20,000 down payment is 5 years and 10 months. And that is with a PMI of 1%.
Once you no longer have to pay a PMI, it takes longer to recover the down payment you invested. If you paid a $40,000 down payment, it would take nearly 14 years before you start saving money. It gets worse. These calculations don’t take into account the opportunity cost of investing your money in a down payment as opposed to another investment, such as stocks or bonds. If you are not planning to stay in your house for that long, you might need to do some number crunching to figure out how much down payment you are willing to invest.
Note: These examples assume the borrower will keep the same mortgage term of 30 years. The overall interest savings would be higher if you reduce the term of the loan.
How much should you put down on your home?
To make a decision about how much your down payment should be, you should consider the following questions:
- How much of a mortgage payment can you afford comfortably with your current budget?
- How long do you intend to live in the home you purchase?
- Will increasing the down payment amount lower your interest rate sufficiently to make it worth your while?
- Will increasing the down payment amount help you get a loan?
- Do you have enough extra money after a down payment to pay closing costs, moving expenses, and any other expenses that might come along?
- Will you have to wipe out a savings account, college fund, retirement fund, or emergency fund to make your down payment?
- Would you be better off using any extra down payment money to pay off unsecured debt and improve your credit score?
The answers to all these questions will help you decide how much down payment you can realistically afford. A reasonable down payment will help you get the loan you want, with the interest rate and term you want. A reputable mortgage company will work diligently with you to find the loan that best meets your needs with a down payment you can afford. Are you ready to buy a home now? If so, you can find the best mortgage companies here.