If you’re looking to buy a home, you’ll have to figure out how much of a down payment you’ll need. And you have some options.
If you’re thinking about buying a home, you need to figure out your down payment.
There was a time when homebuyers could just “assume” the loan of the previous homeowner. That meant that with a small amount of money down, the new buyer could just pick up where the previous homeowner left off on mortgage payments. That’s how my folks bought their first home more than half a century ago.
The advantages are obvious: you don’t have to negotiate a higher asking price. You also don’t have to go through the mortgage process, since the mortgage already exists.
However, homebuyers no longer have that option, so that one’s off the table.
When you visit real estate sites like Redfin, which I found to be one of the best at estimating mortgage payments, the default down payment is always 20%. That means that when you find a mortgage payment that looks attractive, it assume you’re putting down one-fifth of the purchase price first.
Think about that for a second: If you find your dream home with a $300,000 price tag, your down payment would be $60,000.
Do you have $60,000 sitting there in the bank doing nothing? If you do, I salute you. I didn’t.
You can certainly buy a home with a smaller down payment. But I’d wager that for the average person, even a 10% down payment isn’t a reality.
You can find first-time homebuyer programs that allow you put down as little as 3.5% down. For that $300,000 home, you’d then be looking at $10,500. For some, that’s still an impossible total. But for others, it might be doable.
Some lenders may even have their own programs. My lender, for example, allowed me to put 3% down. You wouldn’t think a half-percentage point would make a difference. But for a $300,000 home, that’s a difference of $1,500, which would take your total down to just four digits.
If you put less down, you’ll pay a monthly fee.
My home didn’t cost anywhere near $300,000. As a single guy, that price tag would have been well out of my range. But I knew that I still couldn’t have come close to the 20% down payment for the home I wanted.
I took advantage of my lender’s 3% down program.
But if you check out those mortgage calculators, a curious thing happens when you lower the amount you put down. You suddenly find there’s another item added to your monthly payment: PMI. It’s a fee you’ll have to pay monthly.
PMI stands for private mortgage insurance. Think of it as an insurance policy that protects your lender if you can’t pay your mortgage. If you can’t put down enough to reach that 20% threshold, your lender will insist on PMI.
A mortgage calculator can usually give you a decent idea of how much you’ll have to pay.
But you should also ask your lender about how long you’ll have to pay it. In most cases, you pay until your payments earn you 20% equity in your home. At that point, the PMI payments can end. My lender projected that I’d be paying PMI for the first 10 years of my mortgage. I’m not sure whether that’s a guess or a set rule, but most sources state a 20% equity cutoff, not a 10-year cutoff. But I’ll let you know in 2030.
Your credit score affects how much PMI you pay. If your credit score is strong, that’ll help. If it’s low, not only will you face potential problems in getting a mortgage approval, you’ll probably pay a higher mortgage rate and higher PMI rate if it is approved.
The key is planning ahead.
Figure out what your credit score is for starters. If it’s near or above 700, you should be in good shape. But if it’s lower, you’ll want to work on that. Your lender may be able to give you an idea of what credit score range they want to see. You can also get an idea of your interest rates depending on your FICO score. Everything feels connected, doesn’t it?
If your credit score is good enough, then you need to figure out what you can afford per month for a house payment.
Once you find a good mortgage calculator that will allow you to try multiple scenarios, it will likely estimate what your down payment would need to be to get that monthly payment.
From there, you have to figure out how much money you have on hand and how much you can build to be ready to purchase.
But understand up front: once you have the cash for the down payment ready, that’s not all you’ll have to pay. For a handful of things, you’ll have to start spending money on your new home before you even buy it.
We’ll look at that in the next edition of The Homebuying Process.