When you’re buying a house, the one piece of advice you get from nearly every person is: Save 20% for a down payment. But, in reality, this may not be the best advice for you. So, if you, or your children, want to buy a home, there may be more important factors to consider.
Here’s the Revo Financial guide to saving for a home, including the down payment.
Where did 20% come from?
When you take out a mortgage, you are essentially buying your house slowly, in installments. The more money you pay up front, the bigger percentage of the home you earn from day one. Most lenders want you to have a meaningful equity stake in your home, since it lowers their risk in lending you money.
If you don’t put at least 20% down, those lenders protect themselves via private mortgage insurance (PMI), which is essentially an insurance policy that you’ll continue to pay your mortgage. PMI can be quite costly, and most homeowners wish to avoid it. Legally, once you have enough equity in your home (just over 20%), your PMI is cancelled.
While PMI is a major consideration when buying a house with less than 20% down, it’s still doable.
Buying a house without a big down payment
The biggest factor for buying a house shouldn’t be the down payment or mortgage rates. The decision should be driven by your life and needs. That’s why we’re here to help you plan — because the “rules” can, and sometimes should, be broken so you can meet your goals.
Generally, it’s easier to buy a house when the economy is strong. That usually means banks are more willing to lend money and interest rates are lower. And that can make it easier to buy a house with a smaller down payment, too. But that could cost you more than just PMI. The perceived risk of lending to someone who doesn’t have 20% to put down can also lead to a higher mortgage rate.
In slower economies, or in high-interest rate environments, a higher down payment may be more important since it’s often harder to find and finance a home. Putting more money down can help lower your mortgage rate, saving you money in the long term.
The takeaway is — lower down payments often lead to higher mortgage rates, which mean you’ll likely pay more total interest over the life of your loan. But this isn’t the most important factor in buying a home. There are ways to offset higher rates, like paying extra each month or refinancing to a lower rate if conditions improve.
We can also look at whether you might qualify for an FHA loan, which requires a smaller down payment. And we can also help you evaluate your mortgage options; some banks offer programs to help first-time homeowners who can’t put 20% down.
Help from family
We see a lot of parents who want to help their children with down payments, so we want to take a minute to offer guidance on the best way to do that.
It’s better to give gifts smaller than $15,000 since amounts greater than that are taxed by the IRS. If you want to help out with a larger sum, you may be able to split it up over several years. If the money is a loan and not a gift, it’s good to have a document detailing the repayment terms to prevent miscommunication or problems in the future.
Beyond the tax consideration, getting money from family may be a red flag for a bank. The lender may assume that you are less financially stable if you’re depending on an outside influx of cash. But banks tend to focus on your most recent bank statements, so if you accept a larger sum from family or friends, try to do it several months before applying for a mortgage.
Additional considerations
Some folks suggest first-time home buyers borrow from their 401(k) to help with their down payment. The IRS allows you to borrow up to 10% of your balance. However, we usually recommend against that. Taking money out of your retirement accounts means missing out on potential returns. You also need to pay the money back, which adds a layer of complexity you may not want in the long run. If you want to go this route, we can help you plan for that complexity, but we may encourage you to explore other options first.
The final thing we want to remind you of? The housing market is always changing. It’s likely you’ll calculate the amount you need to save for a 20% down payment based on housing prices when you decide to buy. As you save, housing prices may increase, meaning you need more to hit 20%. (They may also go down, allowing you to hit your goal sooner.)
Plus, down payments aren’t the only upfront cash expense when buying a home. Closing costs can add several thousand dollars to your initial payment.
After considering all the factors at play, you can see why saving 20% down is a good goal to have, but not the only consideration for homebuyers. If you’re thinking of buying a house, or helping your child buy a house, we can work together to figure out a timeline and savings strategy that makes sense for you.
