Unlike most items we purchase these days, a house isn’t something that you can go out and buy today if you decided that you wanted to. It can take months or years of planning before you’re ready to proceed. One of the biggest reasons for this is the need to save money for the down payment—and the larger the down payment, the better. What are the best ways to do it?
Typical Down Payment Requirements
Generally speaking, there are three types of mortgages – conventional, FHA and VA – and each has their own down payment requirements. FHA loans typically require that you make a down payment of 3.5% of the purchase price of the home. VA mortgages typically require no money down at all, but you need to be an eligible veteran in order to qualify, and you may be required to pay a funding fee to the VA.
Conventional mortgages – which are non-FHA, non-VA mortgages – aren’t nearly as simple. Down payment requirements will depend upon:
- The purchase price of the home (“conforming loan amount” vs. “non-conforming”)
- The quality of your credit
- The stability of your income
- Your debt-to-income ratios
- The amount cash reserves you will have (savings you will have left over after the closing)
Though conventional mortgages usually have down payments as low as 5% available, qualifying for them can be extremely difficult. You’ll have to be at the upper end of the quality range on all of the criteria listed above. For the most part, you can generally expect to make a 10% down payment if you’re using conventional financing. And if your situation is at all impaired, you may be required to make a 20% down payment.
But whether the loan is conventional, FHA or VA, you may still need more than your down payment in order to buy the house. You may have to pay closing costs and establish escrows for taxes and insurance. Closing costs typically range anywhere from 2% to 6% of the loan amount, while escrows will depend upon your monthly property tax and insurance requirements. Along with homeowners insurance, we also recommend carrying a mortgage life insurance policy!
A 10% payment could mean that you will need 15% of the purchase price up front. How can you accumulate that much money?
How to Save for a House Downpayment
One of the best ways to save is to do this is through payroll savings. While most people have their paychecks direct deposited into their checking accounts, you could allocate a certain portion of your net pay to go to a savings account that will be earmarked specifically for the down payment on a new home.
If your net pay for example, is $5,000 per month, you can save up $12,000 in just two years by direct depositing $500 per month into your savings account. Even if this doesn’t get you entirely to your savings goal, it will be an excellent foundation that you can supplement from other sources.
Eliminate Bills and Redirect the Money into Savings
One of the best ways to increase the amount of money that you have put into savings is by eliminating certain bills and redirecting the money into savings. For example, you can eliminate cable TV, give up one restaurant meal per week, quit a gym membership, and make some deep cuts in your grocery bill as a way to increase your savings by several hundred dollars per month.
Save Financial Windfalls
This is one of the easiest ways to build up your savings, and it can be even easier to accomplish if you have a goal such as saving money for the down payment on a house to motivate you. Anytime you get a financial windfall of any kind – and income tax refund, a bonus, a gift from a family member – you simply put it into your down payment savings account. This can add several thousand dollars to the account in just one year.
Sell Whatever Isn’t Nailed Down
This method is an extension of banking financial windfalls, except that you’re actively creating those windfalls. Sell what you have that you don’t absolutely need, and add the cash to your savings. You can do this through garage sales, through eBay, or through Craigslist.
An even more innovative way to do this would be to sell an asset that has a loan attached to it. Let’s say that you have a second car that’s worth $10,000 and has a $5,000 loan balance on it. By selling the car, you can pay off the loan, and get $5,000 in cash. This can be a double win. If you use the cash to buy a $3,000 “beater” to replace the car, you can bank $2,000, but you can also redirect the money that was going for car payments into savings as well. This will fast-forward your effort.
Get a gift from a family member
This is the easiest way around the down payment dilemma. Under FHA guidelines, the entire down payment plus closing costs can come from a gift (you only need $200 of your own money in the deal – if that requirement is ever even enforced). Your entire down payment can be a gift with conventional loans as well IF the total down payment on the property is at least 20%. If it is any less, you will be required to prove that at least 5% of the purchase price is coming out of your own funds.
If you do plan to use gift money make sure to get your ducks in a row ahead of time. The lender will require the following:
- A standard form gift letter executed by the donor – it will confirm that the money is, in fact, a gift and that repayment is not required
- Evidence that the donor has the financial ability to give the gift, typically in the form of copies of their most recent bank statements on the account the funds will be coming from
- Evidence that the money has been transferred to your account (and from the donor’s account)
- The donors funds cannot be borrowed
Since the lender will verify the donor’s funds, be sure that the person (or people) giving the gift will be OK with this. Some donors react negatively to being questioned or needing to provide documentation by your lender.
Get the seller to pay the closing costs
This can be a real advantage because it will limit your cash up front to the down payment alone. Mortgage lenders will generally allow the seller to pay up to 6% of the loan amount in closing costs (but less on certain loan types). Sellers will often offer to do so as an inducement to sell their homes.
Whether or not you will be able to do this – and to what degree – will depend on real estate practices in your area and the current market situation. If it is common, the seller will expect to pay it, but if not, the lender may prohibit it. Lenders only allow seller paid closing costs in markets where it is typical.
Benefits to a Large House Downpayment
There are a number of advantages to a bigger down payment:
Lower Interest Rate
Even with our minimal down payment, we still qualified for the best available interest rate. We had gone through an income audit in order to qualify as a self-employed person, and we had excellent credit.
These days, though, a bigger down payment can help you get a better deal on interest. If you pay points, you can get an even better deal. The lower the interest rate, the less you pay over the long haul. A bigger down payment now can mean less money paid during the loan term.
The larger your down payment, the less you borrow. If you borrow less, you pay less in total costs, since the principal you are paying interest on is lower.
On top of that, your smaller loan amount means that you automatically have more equity — or ownership — in your home. This is a good thing. If you end up really needing it, your equity can help you in the long run.
Plus, if you use a 20% down payment, you won’t have to pay private mortgage insurance in a conventional loan. That is yet another way to save money on your mortgage.
Reduce Difficulties When You Sell
One of the big reasons that I wish we had made a bigger down payment is that we wouldn’t be upside down on our home right now. The value of our home has dropped a bit since we bought it (not a surprise). We have about $3,000 negative equity right now. A bigger down payment would have meant that we would still be in the black.
Since we’re not trying to sell right now, it’s not a huge deal. We can easily afford our mortgage payments. However, if you are trying to sell, it can be more of a problem. People who have sold in our neighborhood are selling for $15,000 to $20,000 less than they paid. Those who made large down payments have no problem making the sale and moving on. Even with the need to sell for so little, they still owe less than they are selling for.
Those who didn’t make the big down payment, though, are struggling since they have to get approval for a short sale or consider ruining their credit a great deal by walking away and accepting foreclosure. In a tough market like this, not being able to sell your house can be a big deal, and you have a harder time dropping the price if you didn’t have a big down payment to give you breathing room
Planning ahead, and saving up for a significant down payment is a good financial strategy. You save money over time, and you end up with more options.
Have you used any of these methods for the down payment on your home, or do you plan to on your next purchase?